FOMC to Leave Interest Rates Unchanged

The United States Federal Reserve’s interest rate announcement and accompanying statement is scheduled to be released today at 2:15 PM Eastern Standard Time.  Barring a complete surprise, the Fed is likely to leave interest rates at 5.25% and issue a statement hawkish on inflation.  With contradictory data regarding economic growth and interest rates, the bank cannot do any more.  A move in either direction would prove harmful.

Economic growth in the United States is actually rather sluggish and does not bode well for the US dollar.  In today’s GDP report, we saw that the economy grew 0.7% in the first quarter of 2007, the slowest pace in four years.  This number was higher than the estimates last month of 0.6% but lower than the forecast of 0.8%.  The economy certainly is not growing at the pace it was last year, when the last quarter of 2006 registered growth of 2.5%.

Various sectors of the economy have felt the effects of the economic slowdown.  The housing market is undergoing it biggest slump in two decades.  Demand for housing seems to fall with every new report, and the sub prime woes have led to the number of foreclosures reaching record highs.  Consumer spending, which makes up the largest portion of the US economy, is cooling, mainly due to higher energy prices.  Its growth this quarter is half what it was last quarter.  Business investment is also falling, suggesting that the slow growth this quarter may not be an aberration.  Yesterday’s durable goods report showcased a larger than expected drop in May.

But even considering all this bad news, the FOMC cannot lower interest rates to stimulate the economy.  And the reason why is rising inflation.  Prices continue to rise, at a pace with which the Fed is certainly not comfortable.  Today’s numbers showed a 2.4% rise in core inflation, stripping out food and energy costs.  That is certainly discomforting to policy makers, especially compared to the 2.2% rise that was expected.  And when you consider that the Fed under Chairman Bernanke has professed to prefer inflation within a 1-2% range, you further get the sense that inflation is a big worry.  That is why interest rates are not likely to change, and the statement from the Fed is bound to be tough on inflation (Kathy Lien has a more detailed discussion of the Fed’s decision on interest rates).

What does the Fed’s announcement mean for the US dollar?  The cable should continue to rise, especially in anticipation of the likely interest rate hike in the next BoE meeting.  GBP/USD should not have much trouble staying above 2.000.  The euro should see some gains as well, with similar expectations on the interest rate decision of the ECB.  The yen is a little bit more interesting.  With core prices falling yesterday, the country’s battle with deflation is not yet over.  As long as the Fed remains consistently hawkish in its statement, we might see a reversal of yen gains against the dollar with USD/JPY testing 125.00 soon.