Federal Reserve & Interest Rates

The world’s leading finance ministers met this week to discuss the deepening financial crisis that is quickly spreading across the globe.  The Group of Seven will have their work cut out for them as stock markets plunge and credit markets freeze up.

“The current situation calls for urgent and exceptional action,” the finance ministers and central bankers said in a 266-word statement after talks in Washington. They pledged to “take all necessary steps to unfreeze credit and money markets” without detailing how that would be accomplished.

With a global recession looming, the officials promised to ensure major banks have access to cash and are able to tap public funds for capital. By refraining from specific new measures such as embracing a U.K. plan to guarantee loans between banks, they run the risk of disappointing investors and exacerbating the turmoil.

The big question is whether this is all talk or if the nations of the world can really work together.  Granted just this week a number of central banks joined together to cut interest rates.

It will be hard for each country to not look out for what’s in their best interests and that may be the case for the U.S. especially.  While most of the world concentrated on maintaining price stability as the financial crisis started to rear it’s ugly head last year, the Fed cut rates time after time in order to maintain economic growth.

Another thing to consider is some of the hard feeling across the globe as most countries blame the U.S. for their current financial problems.  The already volatile exchange markets won’t be helped when the U.S. government starts to flood the market with Treasury Securities to pay for all the programs it has initiated to deal with the credit crisis.

For the most part the U.S. has always played to their own tune and I don’t see that changing  appreciably no matter what the cost to the rest of the world.  If other countries don’t follow our lead, they could quickly be left in the dust.

It has become clear that in order to avoid a severe financial catastrophe, the U.S. government is going to have to spend an unprecedented amount of tax payer dollars.

The U.S. Treasury Department is working through the weekend with Congress to craft a plan to spend as much as $700 billion to absorb bad mortgages and other assets from bank or other institution balance sheets to keep the financial system from collapsing.

The Treasury plan, which follows a new federal guarantee for money market fund holdings, would push Washington’s potential bailout tab to $1.8 trillion.

When added to the $300 billion housing bill that entailed the Fannie and Freddie rescue plan, the economic stimulus package, the previous bailout of Bear Stearns, the Fed’s loan to AIG and so forth, you get the picture.  Considering that the existing national debt of the U.S. government is roughly $9 trillion, that’s an additional 20% that could potentially be added to it and with the fact that the financial crisis is far from over, that number could rise even further.

The long term repercussions to the U.S. dollar could be staggering, that’s a considerable amount of additional Treasury Securities the government will have to issue in order to fund that debt.  Added to the fact that the U.S. hasn’t had a government surplus in decades could potentially degrade the credit worthiness of Treasuries in the eyes of foreign investors.

All this taken together spells bad news for the long term standing of the dollar.  Some of it’s effects can already be seen with the slight rebound in the price of oil after the latest bailout was announced.

What we already thought were high commodity prices over the past year could balloon out of control if the dollar hits new record lows as some currency experts are predicting.  The inflationary pressures which have abated somewhat since the middle of summer could quickly return with a bang.

The recession that many economists have long predicted may now be unavoidable and it’s uncertain if the U.S. government will be able to spend it’s way out of this mess.

The price of crude oil has continued it’s downward trend into September as Mother Nature and foreign conflicts have only been able to stall it’s decline over the past three weeks.  We saw oil try to rally on a couple of occasions since it fall from it’s mid-July record of $147.

The outbreak of hostilities between Georgia and Russia which put at risk a major oil pipeline only caused a minor hiccup.  Fears of offshore drilling disruptions from Hurricane Gustav saw oil prices shoot up $6 dollars in one day only to fall by the same amount the following trading session.

The rise of the dollar has played a large part in the general retreat in the commodities market.  After falling to record lows that coincided with oil’s record highs, there is a real feeling that we could be seeing the dollar beginning a period of renewed strength.

This a highly volatile market with large movement swings happening in both direction.  We could easily see oil try to rally again if hurricane activity threatens the Gulf Coast drilling sites.

The same could be said about the dollar, no one knows how it will react in the upcoming months and if it starts to fall again we could see a lot of traders jumping back into commodities.  Analysts are carefully watching the European markets, as long as their economic growth lags behind ours, the dollar should gain in strength.

Central banks will also play a major role as the relative interest rates of each country are a large factor in exchange rates.  At the moment the Fed is more interested in economic growth, while the EU has maintained it stance against inflation, as for Japan, their interest rates are even lower than ours.

Has the oil bubble burst for good?  You still have a lot of traders out there who think oil can recover and break $150 by the end of the year.  Hopefully it will fall to $80, which oil producers believe should be it’s normal price range.