Ahead of the Fed: Oil and the Dollar

The Federal Reserve Board of Governers will meet today to vote on the level of the all-important federal funds rate. The federal funds rate is the overnight rate at which banks can lend federal funds to one another. By law, depository institutions, such as banks, are required to maintain a certain level of reserves with the Fed. A bank's level of reserves will vary day by day as its customers deposit and withdraw money. When a particular bank falls short of the required reserves, for whatever reason, they'll have to borrow funds from another bank with excess money. The rate they borrow at is the federal funds rate.

The Fed's goal in setting the rate is to achieve consistent economic growth, while at the same time controlling inflation. On the growth side, the Fed will consider US manufacturing, which recently has stagnated; consumer spending, which in June fell as oil and food prices have risen; continued weakness in credit facilities; and a deeper housing contraction.

On the inflation side it's all about energy and oil prices, which in the past few weeks have seen major price contractions, since reaching all time highs. The Consumer Price Index, which tracks the prices of goods in the US continues to be relatively high due in part to high energy and transportation costs.

It's a fine line that the Fed has to walk, sustaining growth while keeping inflation in check. Most analysts are expecting the Fed to keep rates steady at 2.00%. The risks of inflation still are heavily outweighed by the sluggish economy. However, we can expect the Fed to increase their inflation rhetoric, as the CPI rose 1.1% in June, the biggest gain since September of 2005, and energy prices remain relatively high.

I expect that any increase in inflation language will cause the dollar to strengthen and oil to weaken. Remember that since oil is denominated in dollars, its price acts as a hedge against a weakening dollar and vice versa. So, if the Fed hints that they'll raise rates in the future, the dollar is likely to get a short term boost, and the price of oil will go down. You can gain exposure to a strengthening dollar through the PowerShares DB U.S. Dollar Bullish Fund (UUP), and to oil through the US Oil Fund ETF (USO).

Disclosure: I currently have no positions in any of the funds mentioned in this article.

Comments

[Larry Gagnonl:]

Extremely well written.
Concise & informative.
Larry G.

[e-mail]

2008 Aug 05 08:28 AM

[paulsjj:]

How about the purchasing power of the dollar? Keeping CPI inflation under 2.5% is also de-valuing the dollar. It takes 22.10 2008 dollars to equal one (1) 1913 dollar. Thats the Fed's real record. All these big company's are trying to get ahead of the debased dollars with excessive trading and leverage and then fold up.

2008 Aug 05 08:54 AM

[User 143167:]

Inflation is NOT about oil, but about the speed that Dollar is created.

2008 Aug 05 10:32 AM

[NOWHEREMAN:]

and the trunover rate of the money supply created.

2008 Aug 05 10:38 AM

[Neal Vander...:]

the fed will have to cut to stimulate the economy and deal with higher inflation.

2008 Aug 05 12:59 PM

[CLH:]

The inflation was short term and caused by high food and energy prices which are now correcting. (not real inflation ) People are still spending and unemployment is not high. (If you want to see high unemployment look at Europe) The dollar is now becoming stronger-- meaning lower oil and commodity prices.

Everything looks good as we come out of the housing bubble. Good post JC.

2008 Aug 05 02:26 PM