Tuesday, August 8, 2006

Fed pauses on rate hikes, but door left open

OK, so there we have it.

No interest rate hikes this period following a 9-to-1 decision from the Federal Open Market Committee, which means the streak of the past 17 consecutive interest rate hikes to slow down the U.S. economy and control inflation officially comes to an end today. The federal funds rate, which is the rate at which the Federal Reserve Bank lends US dollars out to fellow banks, will remain at 5.25%.

So how did markets respond? All of the key U.S. market exchanges ended down today and inflation remains a huge worry for investors.

A rate hike would have tightened the U.S. money supply and have further controlled an already high rate of inflation in the country, as measured by the consumer price index or CPI (the CIP is just one tool used by economists to measure inflation) of 4% in 2006 year on year. Typically the U.S. CPI (rate of inflation) has averaged around 2.7% per year since 2000.

What does the FOMC pause mean to the average American consumer? It means that loan and mortgage rates will not rise in the short term, but that prices for everyday goods and services, including energy and food, will likely rise in the coming months. It will also mean that the US dollar's value will gradually decline even more, and hence the value of US dollar-based investments will decline, and the purchasing power of the U.S. dollar to buy foreign goods will likely also decline.

This tactic to cheapen the U.S. dollar's value plays well when one considers the massive debt that is accruing by the U.S. government and only slowly being paid down.
The brilliant plan of borrowing $5.00 on Monday, but paying back only $3.50 on Friday makes good financial sense for as long as you can get away with it.

In the short term, that tactic appears to work like magic. But eventually global investors in U.S. dollars will catch on to this idea and quickly tire of getting the shaft. If the dollar devaluation strategy continues, the U.S. dollar may eventually lose its magical luster as investors decide to place their assets in other currencies and investment vehicles to achieve their desired returns.

Federal Reserve Chairman, Ben Bernanke, and the Federal Open Market Committee reconvene on September 20 to determine whether rates will be paused again or possibly increased. Based on today's comments statement by the FOMC, the door for future rate hikes has been left wide open.

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