Fed: Hawkish Bias Sole Prop For The Dollar

Fed: Hawkish Bias Sole Prop For The Dollar

Despite relatively strong evidence of a slowdown in the U.S. economy, U.S. monetary policy is unlikely to loosen for the rest of the year. As we recently noted in one of our reports, “If you want to know why the Federal Reserve refuses to budge from their hawkish inflation bias, all you have to do is look at the price of oil. Since the beginning of the year, crude prices have increased over 40 percent with the price per barrel now back above $70. Oil prices have a big impact on inflationary pressures both here in the U.S. as well as globally. “Indeed, the Fed made the same point in the latest FOMC statement noting that, “Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.” The Fed’s continued bias towards inflation rather than growth remains the single greatest fundamental support for the dollar. At 5.25%, the Greenback yields are still superior to that of the euro, providing a 125 basis point positive spread. It is, however, unlikely that the Fed would consider another rate hike, unless headline inflation suddenly spiked well above 3%. Instead, dollar longs may be vulnerable to a rate cut at the very end of the year if consumer slowdown, led by housing, turns into an actual economic contraction. The key variable to watch going forward will be employment. As long as monthly NFP numbers print at 100K or above, the Fed will be free to keep rates at current levels. However, should employment growth begin to falter as the second half of 2007 progresses, the pressure to loosen monetary policy will grow tremendously. It will be particularly intense due to the upcoming 2008 U.S. elections, as monetary officials will be lobbied mercilessly by politicians to stimulate the economy ahead of the election cycle.