CALDEIRÃO DE BOLSA

The banking industry is in a quagmire but the economy really isn't in that dire shape. And inflation is still an issue. What's Ben Bernanke and company to do?
December 13 2007: 1:02 PM EST



Andrew Freris of BNP Paribas on central banks and U.S. Federal Reserve efforts to end the credit crunch.
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NEW YORK (CNNMoney.com) -- The financial services industry is reeling due to exposure to bad subprime mortgage loans. But some market observers suggest that the rest of the economy is still in relatively decent shape, which could mean that the Federal Reserve may not cut interest rates that much further in 2008.

On Thursday, the government reported that the Producer Price Index, which measures wholesale prices, rose 3.2 percent, the biggest jump in 34 years. To be sure, much of this increase was due to soaring oil prices.

But the so-called core PPI number, which excludes volatile energy and food prices, rose 0.4 percent, above Wall Street's expectations of just a 0.2 percent increase. This could be a sign that inflation is still a concern.

What's more, despite all the doom and gloom about the housing market, the Commerce Department reported Thursday that retail sales surged 1.2 percent in November. And even if you exclude sales at gas stations, which were obviously juiced by rising prices at the pump, sales were still up a healthy 0.6 percent.

Largest jump in 34 years for wholesale prices
Add this up and the Fed's two big announcements this week suddenly seem to make a lot more sense.

"It's clear that the economy's moderation in recent months has been relatively gentle. There has been no outright collapse," said David Resler, chief economist with Nomura Securities International. "The economy may be on the soft side, but that doesn't mean we're going into a recession."

The Federal Reserve cut two key interest rates by only a quarter of a percentage point Tuesday, a move that caused Wall Street to panic. The Dow plunged nearly 300 points.

Many investors were hoping for a half-point cut, or at the very least, a half-point cut to the discount rate, which is what it costs banks to borrow directly from the Fed. But Wednesday, Ben Bernanke & Co. saved face somewhat by announcing a plan to inject billions of dollars into the banking system.

In conjunction with several other central banks in Canada and Europe, the Fed said it would conduct four auctions in the next month that will allow banks to bid for loans. Sources said it will probably cost banks less than the 4.75 percent discount rate to borrow money this way.

The combination of a mild rate cut and the new auction system seems to indicate that the Fed is looking for a creative way to solve the credit crunch on Wall Street rather than by simply slashing interest rates.

Fed looks to end credit crunch
And considering the inflation and retail sales numbers released Thursday, some experts said the Fed would be wise to stick to this strategy.

"With higher inflation than expected and strong retail sales, it's hard to justify aggressive easing," said David Wyss, chief economist with Standard & Poor's. "I'm sure they are glad they did a quarter-point cut and not a half-point cut."

Investors don't seem to be that thrilled by the stronger-than-expected economic news since it may dampen rate cut hopes. The Dow dipped about 70 points, or 0.5 percent, in midday trading Thursday while the Nasdaq and S&P 500 each fell nearly 1 percent.

The Fed is in a tough spot since the financial markets clearly want the central bank to be proactive in order to make sure the liquidity crisis doesn't spill over into the broader economy and cause a recession. Still, there's little to suggest as of yet that this is actually happening.

"Going into Tuesday, if you just looked at what's going on in the financial markets, you would have cut by 50 basis points (a half percentage point). But if you look at just the economic data, you would have done nothing," said Steve Van Order, fixed income strategist with Calvert Asset Management Co., a Bethesda, Md.-based investment firm with $16.1 billion in assets under management.

Van Order hailed Wednesday's auction plan as a "smart and creative" move by central banks, and said that this could help the Fed address credit concerns without having to cut rates sharply, which it clearly does not want to do.

"The Fed might feel a little closed in by economic data that isn't too bad and inflation numbers that are showing higher commodity prices. The market was trying to twist the Fed's arm," Van Order said. "But by addressing the liquidity crunch it won't have to cut the fed funds rates that aggressively. It may look to do so more cautiously."

Fed cuts rates by quarter-point
Still, some wonder if the Fed's continued focus on inflation is misguided.

Matthew Smith, president and chief investment officer with Smith Affiliated Capital, a fixed-income investment firm in New York with $1.8 billion in assets under management, points out that growth in the core PPI over the past 12 months is only 2 percent. The Fed is widely believed to be comfortable with inflation within a 1 to 2 percent range.

"The Fed does not need to be concerned about inflation," Smith said. "The Fed made a mistake by only cutting by quarter of a point. By continuing to just cut by a quarter-point, it's prolonging the inevitable and is behind the curve in terms of solving the credit problem."

Nomura's Resler also said that inflation is not a major issue. He added that it will be more important to see how much retail prices are rising.

To that end, the government will report the Consumer Price Index on Friday. Economists are forecasting a 0.6 percent increase in the overall CPI and a 0.2 percent increase in the core number.

"The Fed should not be complacent about inflation but there are reasons to think consumer prices won't be as up as much as producer prices," Resler said.

With all this in mind, it's starting to look like the Fed will probably continue to take a relatively measured, to use a favorite word of Fed statements past, approach to interest rate cuts at its next meeting, a two-day session that wraps up on Jan. 30., and beyond.

According to futures trading on the Chicago Board of Trade, investors are pricing in a strong likelihood that the Fed will cut its federal funds rate by only a quarter-point, to 4 percent. Traders are also split as to whether the Fed will cut rates again at its March 18 meeting.

"The Fed doesn't feel big rate cuts are necessary. This is a financial markets and housing problem, but so far, it's a minor problem for the overall economy," Standard & Poor's Wyss said.

Bet your bottom dollar
The Fed's last two rate cuts helped send the greenback drastically lower. But experts say the worst may be over for the dollar even if the Fed cuts again.
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December 11 2007: 3:37 AM EST


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NEW YORK (CNNMoney.com) -- Wall Street is betting that the Federal Reserve will deliver another rate cut at its policy meeting Tuesday, but that may not necessarily spell more doom for the dollar.

Currency experts argue that the greenback's steep decline this year has come too far, too fast and that investors have factored in one, if not more, rates cut by the Fed in the coming months.

"At these levels quite a bit of interest rate reduction is already priced into the dollar," said Shaun Osborne, chief currency strategist in Toronto at TD Securities Inc.

The dollar has managed a modest recovery in recent weeks, but is still sharply lower for the year against a number of currencies, most notably the euro and the British pound.

The U.S. Dollar Index, which measures the currency's performance against six of its biggest trading partners, is down more than 8 percent so far this year, after hitting a record low late last month.

Much of the dollar's recent decline can be blamed on the Fed's recent policy actions. In October, the central bank cut the key federal funds rate, which affects the rate at which consumers borrow on a variety of loans, by a quarter of a percentage point. That followed a half-point cut in September.

A rate cut puts pressure on the dollar since it makes dollar-denominated investments less attractive to outside investors.

Although a weak dollar also typically drives domestic and overseas demand for U.S. goods, it also poses an inflationary risk to the economy by limiting consumers' buying power overseas and pushing up the price of commodities such as oil and gold.

The Fed's plan B
Traders are split as to whether the Fed will lower the federal funds rate by a quarter-point or a half-point on Tuesday.

But Tom Fitzpatrick, global head of currency strategy at Citigroup in New York, said that if the Fed cuts by a half-point, he thinks there would be "quite a sharp reaction in terms of dollar selling."

With a rate cut all but certain though, Fitzpatrick and other currency experts said investors are likely to pay close attention to what the Fed says in its statement.

At its October meeting, policymakers said that the risks of inflation and economic growth were roughly in balance. If they stick to that same script, that could bode well for the dollar, said Nick Bennenbroek, head currency strategist at Wells Fargo Bank in New York.

"The key question is whether they feel comfortable or bold enough to repeat that assertion," said Bennenbroek. "If that statement is there, then we might see the dollar stabilize or even move higher."

Whatever action the Fed takes on Tuesday, there have been encouraging signs for the U.S. economy - a bullish indicator for the greenback.

Last Friday, the Labor Department reported that the economy added 94,000 jobs in November, while the unemployment rate held steady, suggesting that the U.S. economy was unlikely to enter a recession in 2008.

"I think perhaps there is a window here for the dollar to do a little better for the next few quarters," said TD Securities' Osborne.