Fed’s philosophical recipe for creditors

Fed’s philosophical recipe for creditors

Tuesday’s unexpected deep cut in the overnight US interest rate hurt the dollar right away. That adjustment was almost mechanical. But the greater risk to the greenback comes later, when US creditors digest the Federal Reserve’s philosophical leanings.

Currency traders follow some basic rules. One of them is that currencies which yield less are worthless. So when the US central bank cut by 50 basis points, instead of the roughly 35 bps that had been priced in to the futures market, the dollar fell—by 0.5-0.8% against the euro, yen and sterling as of Wednesday morning.

The Fed’s tone in its intensely studied statement accompanying the announcement adds to short-term pressure. Traders take the emphasis on “developments in financial markets" as a sign that further cuts are likely, unless markets return quickly to something close to their pre-August state.

But while traders can dominate currency market action for a while, longer-term investors triumph in the end. For the US, which has to finance a gargantuan trade deficit, the willingness of foreigners to make dollar-denominated investments is crucial.

If these trading partners were to decide to accept only US goods, not US securities, the dollar would tumble—by 30-40%, according to most economists.

Many of the foreigners are as interested in US stability as in interest income. That matters, since the Fed’s first big decision under chairman Ben Bernanke could make the US look like a less stable destination for investment.

The Bernanke Fed’s willingness to cut rates sharply to “forestall" possible slower growth suggests that it thinks slow growth is a greater danger than high inflation. If inflation were the main worry, record oil prices and still low US unemployment rates would probably have forestalled a rate cut, let alone an unexpectedly large one.

Trust in the inflation-fighting credentials of US authorities isn’t the only reason to buy dollar-denominated securities, but it is one of the pillars that support the trade deficit. If that trust is eroded, the dollar could be much more vulnerable than simple interest rate calculations might suggest.