US Dollar Falls But That’s a Good Thing

The discount rate in the United States was lowered today from 6.25% to 5.75%.  The 50 basis point reduction was a necessary move to stave off credit market gridlock (at the very least, it will satisfy Jim Cramer).  With regard to the foreign exchange markets, volatility is approaching the crazy days of October 1998.  The liquidity injections by the major central banks have obviously not been doing the job in easing the credit crunch, and the lowering of the discount rate sends a major message to the international financial markets.

The discount rate is the interest rate at which the Federal Reserve lends money to major banks, as opposed to the Federal Funds rate which is the overnight lending rate between banks (check out dailyfx.com for a more detailed look at the difference between the discount rate and the Fed Funds rate).  By not touching the benchmark interest rate, the Fed is trying to avoid the moral hazard problems.  Central banks around the world are loath to bail out completely the financial institutions that lent out money so irresponsibly.  But the economic impact on the borrowers and on the “real economy” has become so profound, that the Fed needs to do something.

When it comes to trading currencies, the primary effect of this morning’s decision is a removal of support for the US dollar.  Accompanying the discount rate announcement was a dovish statement by the Fed stressing economic growth and deemphasizing the fight against inflation.  A September 18 rate cut is as close to a certainty as is possible.  But that weakness is compounded when you realize the psychological effects of the Fed’s decision.  Now we know that the US central bank stands at the ready to ensure proper credit movement, and with removal of some risk, more daring investments come into play.  And there’s less of an incentive to hold cash (or T-bonds, which are just about the same thing).  People do not care anymore about the US dollar’s safe haven status, and that is reflected by the fact that the currency fell against 14 or the 16 most highly traded currencies.  Dollar bulls are going to eat some losses now, but today’s news is good news for the global economy as a whole.  And ultimately, that’s good news for the dollar.