A more attractive offer

Exactly one month ago I came to the conclusion that oil is likely to go over $100 per barrel. My reasoning was based upon the actions of the Federal Reserve Bank at the time cutting the discount rate, which implied to the market most strongly that the official rate would be cut. Well, it happened - the rate has been slashed by 50 basis points from 5.25% to 4.75%.

The market, predictably, went wild. It's always amusing to see the graphs of market reactions to certain news and last night's Wilshire 5000 went from zero to hero in the space of 15 minutes. Encouraged by the cut, and seeing in it a decisive action by the Fed, the market invested an extra $432.36 billion into shares (based on the rise in the Wilshire 5000)

But, given the gushing and excitement of the sharemarket, one could easily forget to check out other important market barometers.

Perhaps the most important is the US Dollar. While the sharemarket jumped up the Dollar fell down. It went from €0.72 to €0.7157, a fall of 0.6%, admittedly not huge but, then again, most landslides begin with a few pebbles.

When Ben Bernanke informed the market of his desire to print more money in the form of lower interest rates, he did so in a foreign exchange (forex) environment that has become increasingly hostile to the US Dollar. Like all markets, the forex market operates by supply and demand. By increasing the money supply Bernanke essentially told the forex market that money will be cheaper. With demand not increasing, the only thing the forex market could do was to downgrade the currency. This has been happening for some time now, but when the Fed lowered rates it was a signal that more is to come - which means that the forex market can continue to devalue the dollar.

Of course, one of the results of a dollar losing value is the increased price of imports. This has an inflationary effect, which means that the rate cut is inflationary in nature. Given the fact that inflationary pressure have beset the US economy for some 12 months now, the Fed's actions in lowering rates risks increasing inflation (the deflationary effects of a downturn notwithstanding). If the forex market continues to punish the US dollar, the Fed may be in the unenviable position of having to choose between runaway inflation or raising interest rates during a recession.

The second market barometer worth noting is the price of oil. Oil is priced in US Dollars and this price depends upon a combination of supply and demand influences as well as the price of the dollar. In other words, the price of oil does not fall whenever the dollar falls - it increases in value if the dollar falls. And, surprise, surprise, the price of oil spiked after Bernanke's announcement and is now hovering around $81 per barrel.

As the US economy begins its slow winding down, international investors are increasingly beginning to see better offers in younger, more attractive economies. Once a virile peacock, the US economy is increasingly turning into a bitter old rooster. The Subprime meltdown is the beginning of the end of America's most favoured status amongst the world's economies, and the result will be a protracted, painful recession and economic realignment. By cutting rates, the Fed has chosen to make it easy today and harder tomorrow.