How Will the Federal Reserve’s Next Move Affect the USD?

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If at the beginning of the year the Federal Reserve was talking about starting to tighten monetary policy and exit strategies, abundance of negative economic data in recent months has led the Fed to discuss possible future actions to push the flailing American economy back to life.

While the Federal Reserve’s early actions, mainly reducing the interest rate to almost zero and engage in massive securities buying programs have kept the U.S economy out of a deeper recession, the recovery seems to be much slower than anticipated, with unemployment rates remaining at uncomfortably high levels and inflation a whole 1% below the target rate. These two issues are also the main concern areas for the Fed; one of Bernanke’s main goals is to avoid deflation, a decrease in general price level of goods and services.  

Another major issue dragging down recovery is the housing market. Housing led the U.S. out of seven of the last eight recessions; however, home sales collapsed after a federal tax credit for buyers expired in April, dragging down the manufacturing led expansion, which began in the second half of 2009.

The Federal Reserve’s next meeting will be taking place this weekend in Jackson Hole, Wyoming. The most controversial issue expecting them is the decision of whether or not to print more money and extend their securities purchases. These two actions will expand the Fed’s portfolio’s further; the portfolio is the Fed’s major monetary tool. Another issue is how quickly to act? And if it does decide to act, should it take small, cautious steps or large, dramatic ones? While the Fed and most private forecasters still expect faster growth in 2011, and few economists are predicting outright deflation, few if any economic indicators in recent months support this assumption.

Federal Reserve governors seem to be quite divided over how and when to act next. Some even question whether to act at all.  Richard Fisher, president of the Dallas Fed, and others expressed a concern that Fed moves might be ineffective, arguing that businesses weren’t using already ample, cheap credit to fund investments because they were uncertain about many other problems, including government deficits and new financial regulations.

Investors should pay close attention to the next few meetings as they will likely have great affect on the USD. The greenback has been gaining recently on return to safety as it is considered a safe haven currency. The USD has been gaining despite negative economic data as investors shied away from riskier assets. Furthermore, as the U.S is the world’s largest economy, any economic slowdown is likely to affect global recovery, slowing it down as well. It is expected that if the poor economic conditions continue, the USD will continue to strengthen versus riskier counterparts, however, in case the Fed does decide to expand its monetary easing program this trend may reverse. Excess amounts of currency flooding the markets tend to be very negative for the currency. With shaky economic fundamentals, any excessive intervention by the Fed may hurt the greenbacks status.

It will be interesting to see the developments over the next few months as they will likely have profound effects on the US economy and subsequently global economic recovery as well.