Federal Reserve Meeting This Week: The Dollar Is Crucial

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Summary

The Federal Reserve is not expected to raise its policy rate of interest this week, although some officials have indicated that an increase may occur before year-end.

The value of the US dollar has become crucial in the Fed's deliberations as the United States is a much more open country than it used to be.

Officials at the Fed are more aware of how their actions impact foreign exchange markets within this open environment and cannot ignore the impact they have on the dollar.

The Fed's Federal Open Market Committee (FOMC) is meeting this Wednesday and Thursday.

In recent days and months, the primary attention of analysts and the press has been on the question of whether or not the FOMC will raise the range of its policy rate, the Federal Funds rate, which now stands at 25 basis points to 50 basis points.

For most of the time since the Fed last raised it target range, which came in the middle of December 2015, the effective Federal Funds rate has been around the midpoint of the range averaging 37 basis points. In the past several weeks, since the British vote to leave the European Union, the effective Federal Funds rate has averaged 40 basis points.

Although Fed officials have been talking a little bit more, in the past week or so, about raising the target range again, there seems to be very little likelihood that the central bank will raise the rate at this week's meeting.

These Fed officials have started talking up a possible raise this year because the economic data of the past two weeks have been relatively good, pointing to a possible strengthening of the economy.

But, the data are not that strong and the Federal Reserve, as mentioned in the post cited above, has not done the groundwork, as they did before the December move, for raising the rate at this time. Hints are that such a rise might come in September - or, at least before the end of the year.

I am more interested, however, in what is going on in the foreign exchange market and how the Fed's decision will play in the future of the dollar.

The Federal Reserve, over the past thirty months or so, has really played on the financial markets, and consequently, on the foreign exchange markets.

In October 2014, the Federal Reserve ceased its third round of quantitative easing. Officials, almost immediately, began to give the markets "forward guidance" about the future of the Fed's policy rate of interest. The "forward guidance" was that it was highly likely that the Fed would make four rate increases in 2015, each of a quarter of a percentage point.

All of 2015 was a confusing scene of the Fed saying it was going to raise its policy rate and then backing off from such a raise because the data didn't warrant such an increase.

Finally, the Fed did raise the rate in December, but many, myself included, believed the increase was just an attempt for Fed officials to "save face" because of the waffling that took place during the year.

But, right after the increase, Fed officials jumped right back into the fray and provided more "forward guidance" for 2016. They signaled that in 2016 there would likely be two more increases in the Federal Funds target range, each raise being 25 basis points.

So, here we are, almost in August, and the Fed is sitting on their hands, not moving rates, with some Fed officials indicating that there might be one increase in the policy rate before the end of the year.

During this past year, it has been interesting to observe what has happened in the foreign exchange market as a consequence of this Federal Reserve indecision and waffling.

As I have written many times over the past thirty months, the foreign exchange markets have wanted the Federal Reserve to raise interest rates. Every time it looked likely that the Fed would raise its policy range, the value of the dollar strengthened, especially against the Euro.

Every time the Fed backed off from such an increase, the value of the dollar weakened, especially against the Euro.

The one lesson we should have learned over the past thirty months or so, is that the US economy is not as closed as it once was. As a consequence, world markets are very sensitive to what the Federal Reserve is doing and that the Federal Reserve cannot just shut its eyes to the rest of the world and conduct its policy on just the domestic concerns of the United States.

Of course, the Fed has not "shut its eyes" on the rest of the world all the time. As is shown in the book former Fed chair Ben Bernanke wrote after leaving the Fed, "The Courage to Act: A Memoir of a Crisis and Its Aftermath," during the financial crisis surrounding the Great Recession, the Federal Reserve played a massive role in world financial markets.

However, since the world ceased to be in a crisis mode, the Fed has once again attempted to get back to "business as usual" and focus just on the two objectives set for it by the US Congress, low unemployment rates and low rates of inflation.

But, the world just won't let the Fed alone. What is going on in the rest of the world just keeps intruding on Federal Reserve policy making.

The primary intruder is the value of the US dollar.

The situation, briefly, is this: The growth of the US economy is about the strongest in the world, even thought it has only grown at a 2.1 percent compound rate of growth for the past seven years. Almost all other developed countries are growing at a slower pace.

Because the growth rate in the US is so low, the Federal Reserve has been reluctant to raise its policy rate of interest. As a consequence, the other central banks in the developed world have had to almost continuously cut their policy rates in an attempt to get their economies growing at a faster pace. The result has been negative rates of interest.

In other words, the Federal Reserve, following the goals set up for it by the US Congress, has kept the lid on world short-term interest rates and created a very precipitous economic climate.

In essence, then, the Federal Reserve has a monetary policy that is the least inflationary in the world and this in the environment for the strength of the US dollar and the reason why investors really want the Fed to raise its policy rate and accept the fact that it must support a strong dollar.

That is, the Federal Reserve must accept the strong value of the dollar as a third policy objective along with the two set for it by Congress. The Federal Reserve must accept the fact that, de facto, it has become the central bank of the world and accept the responsibilities that go along with it.

The federal government must also accept this fact and begin to act accordingly - but, more on this later.

Since the Brexit vote, the value of the US dollar has strengthened again. Right now, the cost of one Euro has dropped below $1.10, and I believe, is heading for the $1.06 to $1.08 range. The value of a British pound is down around $1.31, and I believe, heading for $1.25.

Where is the Fed going to come out on this? I know where I would like it to be.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.