US Rate Cut will stoke inflation

Helicopter Ben delivers:

It appears United States markets have responded positively to the Federal Reserve's decision to cut its key interest rate by 0.75 per cent.

Share prices fell by almost 3 per cent when the New York Stock Exchange opened this morning but at 2am AEDT were only down by 1 per cent.

The Federal Reserve is hoping its biggest single rate cut since 1982 will increase market confidence and help stave off a recession.

Markets in London and Paris also recovered from big losses in early trading, closing almost 3 per cent higher.

Most Asian markets suffered heavy losses, closing before the Federal Reserve announced its rate cut.

It is the first emergency rate cut since September 11 2001, and the biggest single cut since 1982.

Some analysts say the move smells of panic, but the Federal Reserve hopes the surprise cut will increase market confidence and help stave off a recession.

The drastic action to try and calm the financial markets and growing fears of worldwide recession appears to have had a positive effect on world markets.

A 75 basis-point cut is exactly what the markets wanted and it is exactly what they didn't need. It doesn't surprise me in the least that Wall Street jumped up and down in ecstasy in the knowledge that a financial utopia has been delivered just in time.

The effect on the foreign exchange markets was immediate - as soon as Ben's Helicopter dropped the 75 basis point cut, the US Dollar began to devalue again. The reason is simple: more money = cheap money. One of the indices I keep an eye on is the NYBOT, which values the US Dollar against a bunch of other currencies and is the best way of valuing how the Dollar is performing. The US Dollar lost about 1.3% of its value as a result of Ben's Helicopter and more devaluing is likely to occur.

The US has not had inflationary problems since the early 1980s and the US Dollar has remained quite high since that period. But now, with the Dollar tanking over the long term, inflationary expectations are very high. Whenever a currency devalues in the way the US Dollar has, the inevitable result is high inflation.

A 75 basis point cut is something that probably would have worked 4-5 years ago when the US Dollar was strong. With low inflation and a valuable currency, there was plenty of room for error. Indeed, Ben's predecessor, the erstwhile Allan Greenspan, was able to cut rates significantly in early 2001 as the economy moved into recession. There is no margin of error these days, yet the 75 basis point cut (the biggest rate cut since 1982) was still enacted. This will inevitably stoke inflation.

At some point in the next 2-3 months, inflation will rear its ugly head in America. Some commentators will try to downplay its significance but others won't be too sanguine. In any case, the Fed will have only two choices - either raise interest rates to kill inflation, which will be deadly in the midst of a recession, or do nothing, which will convince investors that the Fed is not interested in protecting the dollar. Either way the confidence that the market has in the Fed will be completely shot through, if it hasn't been done already.

And that's a prediction.