Should the Fed Lower Interest Rates?

Should the US Fed lower its overnight lending rate, and what will its decision mean for the US dollar?  The short-term strength of the greenback would surely disappear if rates were indeed lowered in September.  But just as certain is that financial markets would recover faster, and the economy might be stronger going into the end of 2007.  the danger of cutting interest rates (besides the inflationary risks) is the idea that a market bailout by the Federal Reserve would create a moral hazard in the financial industry.

Short-term support for the dollar remains strong.  The dollar is on a steady upward path against the euro and the pound.  It is absolutely killing against commodity currencies.  With risk aversion still dominating the forex market (and the carry trade likely to fall even further), the yen remains the only currency to show strength against the US dollar.  If USD/JPY touches 116.50, we will see all hell break loose; that’s the level at which many retail traders started shorting the yen and their stops will come into play.  Economic data for the greenback has been mixed.  Industrial production and producer prices surprised to the upside.  But the CPI report this morning came in particularly low, as many economists were predicting.

The last development would provide cover for the Fed if Bernanke decided to bail the financial market out with an interest rate cut.  Monetary policy makers could argue that the upside risk of inflation is abating, thereby preserving their inflation-fighting credibility.  But one thing to note is that the liquidity that has been injected into the market in recent days has not exactly been a “helicopter drop.”  The money has gone through the big banks, and there are still reports of smaller companies and mortgage lenders being mired in a liquidity crunch.  The signs of the intervention working are mixed, at best.

But then that points to an interesting question.  Should we bail out lending companies that made foolish decisions resulting in bad loans?  If the financial companies are not held accountable for their poor actions, then we could see even riskier investments and loans flourish in the new environment.  The ideal scenario would be to find some way to help those families stuck paying off impossible mortgages and keep them from losing their homes, but do that without assuming the risk of the larger corporations.  An actual helicopter drop, distributing money to those at the bottom-end of the operation, would be best.  The government would need to get involved.  However, the integrity of the Fed and the US dollar would be maintained, and US consumers would be saved.