Commentary

Fed's hands tied by weak dollar

Yes, the economy is in rough shape. But if the Fed keeps cutting rates, it risks further weakening the anemic dollar...and spurring more inflation.

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By Paul R. La Monica, CNNMoney.com editor at large

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What worries you more about the economy?
  • Rising energy and food prices
  • Weakening job and housing markets
  • Concerned equally about inflation and slow growth
  • Not worried: The economy is fine

NEW YORK (CNNMoney.com) -- The Fed is in a bind. The report last week showing a loss of 63,000 jobs in February was the clearest sign yet that the economy may be heading into recession...if it isn't already in one.

But can the Federal Reserve really afford to cut interest rates by another three-quarters of a percentage point next week, as some are predicting? With inflation still a major cause for concern, the Fed is running out of wiggle room if it hopes to successfully accomplish both of its mandates: keeping inflation in check and ensuring that the economy continues to grow at a steady pace.

The dollar hit a three-year low against the yen Friday and is trading at a near all-time low against the euro. And if the Fed keeps slashing interest rates to prop up the economy, it risks further weakening the dollar.

And that could spur more inflation in commodities such as oil, gold, corn and wheat. In addition, the weak dollar is likely to make the price of imported goods more expensive.

The Fed has to be aware of this and cannot continue to repeatedly hit the rate-cut button.

To be sure, the weak job market should help control inflation since increasing salaries are typically the biggest contributor to rising prices. "Current subdued wage gains and economic weakness in the first half of 2008 should help squash inflation fears over the next few months," wrote David Kelly, chief market strategist with JPMorgan Funds in a note Monday morning.

But inflation is not going away. In fact, according to a recent semiannual survey of investment advisors conducted by Schwab Institutional, a division of brokerage firm Charles Schwab, 62% of advisors surveyed now expect a rise in inflation over the next six months, up from 53% who thought inflation would increase when the survey was last conducted in July 2007.

I'm sure this next comment will anger many that are struggling in these tough economic times but we have to realize that recessions are inevitable parts of economic cycles. The Fed has to do everything it can to make sure that recessions are brief and not too painful but it is irresponsible to forget about the inflation risk.

It's also absurd to suggest that the Fed has sat back and done nothing to try and minimize the pain in the housing and credit markets. The central bank has created a new process, the Term Auction Facility, to lend money to banks in need of short-term funding at a lower interest rate than these banks would normally get by borrowing directly from the Fed at the discount rate.

And the Fed has already cut interest rates by a total of 225 basis points, from 5.25% to 3%, since last September. Many economists and market strategists see the fed funds rate at 2% by late spring. The Fed will be hard-pressed to cut rates much lower than that or it risks creating more problems down the road.

Recession? Who knows?

Keep in mind, one of the most difficult things about a recession is figuring out when they start and when they end.

The National Bureau of Economic Research, the official arbiter of recessions, didn't declare a recession began in March 2001 until November of that year. By then, the Fed had already slashed interest rates and the recession was over, though the NBER didn't say as much until July 2003.

Even so, the chairman Alan Greenspan erred on the side of caution and kept cutting rates. As of June 2003, the Fed Funds rate was just 1%, where it stayed for a year.

We all know what happened next. Hopefully, current Fed chair Ben Bernanke will act more cautiously and not drop the ball on inflation. Another rate cut or two might be the right tonic for this economy. But we also need to sit back and wait for the effects of the previous rate cuts to be fully realized before urging the Fed to keep cutting and cutting.

Bringing interest rates below 2% at a time when oil is over $105 a barrel, gold is marching towards $1,000 an ounce and the dollar is as anemic as it is compared to other leading global currencies seems not only reckless but dangerous.

What do you think? Are you more concerned about rising food and oil prices or the weakness in housing and the job market? To top of page

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