FOMC Announcement Surprisingly Hawkish

The actual interest rate decision yesterday afternoon did not surprise anyone in the forex market. The Fed kept rates the same which, despite the bank’s famous lack of transparency, was predicted by everyone. The announcement accompanying the FOMC decision did provide some short-term support for dollar bulls. But of greater concern for most forex analysts, the longer-term problems afflicting the US dollar are not likely to go away anytime soon.

According to the announcement, the primary concern for the Fed is still trying to control inflation, which is certainly reassuring for those still long US dollar. There are two primary reasons for this track. The first is that the bank looks to be providing a calming voice to the international financial markets. While accepting that the housing crisis is troublesome (and could get worse), the situation is not as bad as it might seem.

Analysts all over the United States are screaming their heads off about the problems in the subprime sector and how they are going to sink the market and how the central bank needs to cut interest rates. But the fact remains that the broader economy continues to do well. And despite the Fed’s dual mandate (of controlling inflation and ensuring economic growth), the fact remains that the bank’s primary job is price stability. While core inflation may be within the target range (1-2%) espoused by Bernanke’s Fed, commodity prices are skyrocketing. Oil is still above $70/barrel and food prices are growing at a 6% annualized rate. The upside risks to inflation remain high, informing much of the bank’s decision to keep interest rates the same.

The second major reason that the FOMC kept interest rates steady is the need to keep returns competitive with the rest of the world. Interest rates are on the rise all over the world, and if the United States lowers its rate, investors realize they can better return to equity elsewhere; US bonds would be inherently less attractive than bonds offered by countries with lower rates. The market still expects interest rate cuts by the beginning of next year, which leaves the US yield curve inverted.

Traders, before anything else, are obsessed with higher returns, and if they cannot find them in the United States, we will see a capital flight away from this country, torpedoing the US dollar. Deterioration in our current account surplus would leave American consumers unable to pay for imports in the short-term, setting the stage for a massive devaluation of the US dollar. The greenback is buoyed by its status as a store of value and by the dollar’s preeminence in international trade, but that’s not going to matter to investors hungry for yield. The Fed’s caught between two problems: the slowing down of the US economy and the need to keep US bonds attractive to international investors. It is this situation that will keep US interest rates the same for some time, keeping a cut at bay for longer than most forex analysts seem to think.