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Cutting time for Bernanke?

Suddenly the markets expect to see another rate cut. Is the dollar's late-summer rebound at risk?

By Colin Barr, senior writer
Last Updated: September 21, 2008: 3:08 PM EDT

NEW YORK (Fortune) -- The U.S. financial crisis has pushed Fed chief Ben Bernanke off the front page lately, but he may soon return with a vengeance.

Treasury Secretary Henry Paulson and Federal Reserve Bank of New York President Timothy Geithner have grabbed the headlines for the past week with their efforts to stabilize the financial system. But in the wake of the nationalization of Fannie Mae and Freddie Mac, Sunday's bankruptcy filing at brokerage firm Lehman Brothers, the rushed sale of Merrill Lynch (MER, Fortune 500) to Bank of America (BAC, Fortune 500), and the efforts to raise new capital for insurer AIG, investors have taken flight from risky assets for the umpteenth time.

The latest surge into Treasury bonds and out of stocks, bonds and other assets has the effect of making liquidity scarce just at the time troubled financial firms need it most. While federal officials have expanded access to emergency borrowing facilities and Wall Street banks have created a $70 billion pool of money for the sake of helping other cash-strapped firms, policymakers have signaled over the past year that in a crunch they'll err on the side of providing excess liquidity.

That's where Bernanke comes in. The Federal Reserve's policymaking Federal Open Market Committee is due to meet Tuesday to issue its latest decision on interest rates. Wall Street has until recently expected the Fed, nearing the anniversary of its first fed funds rate cut in a series that eventually took short-term lending rates down to 2% from 5.25%, to hold the line on rates in a bid to tamp down inflation fears.

But the latest round of tumult in the financial system - along with the tumbling price of crude oil and other commodities whose run-up was responsible for the outsize inflation readings of recent months - may have made that view obsolete. Many market players now expect to see the Fed, after spending several months on the sideline, to cut rates - perhaps sharply - in a bid to reduce the chance the financial system could seize up anew.

"Recent events suggest a large de-leveraging of the banking system is picking up steam and suggests the risks to the economy are entirely concentrated in the growth outlook (inflation concerns will take a back seat, or move to the trunk)," writes Merrill Lynch economist David Rosenberg, who says he expects the Fed to cut its fed funds target to 1.5% from 2% Tuesday. "In that environment, it makes little sense for the Fed to wait."

Trading in the fed funds futures markets suggests market players agree with Rosenberg that a rate cut is on the way, though trading in the Chicago Board of Trade futures shows investors expect a cut of just a quarter of a percentage point, also known as 25 basis points. Rosenberg, however, cautions that "the risk of only going 25 bps at this juncture is that it will be viewed as too tepid a response to these epic contractionary events."

While Fed officials responding to the current crisis may understandably view protecting the integrity of the financial system as their first priority, there is also a risk in cutting rates - the possibility of starting another selloff in the dollar, which had only recently regained strength after spending the better part of six years in near-continuous decline.

After falling as low as $1.60 to the euro in mid-July, the dollar surged to $1.38 to the euro late last week. While that's still a long way from the dollar-euro parity that was last seen in 2002, the rally reflected the view that the U.S. economy may recover more quickly than those in Europe, which after earlier showing signs of strength have slowed sharply. A stronger dollar helps the U.S. economy by making imported goods cheaper and holding down inflation.

But hopes of a speedy U.S. recovery have been dashed by the latest events in the financial sector, which will only serve to add to the burdens being hefted by a weakening economy. The collapse of Lehman will leave many creditors and shareholders with substantial losses that, in the case of financial firms, will further stress already stretched capital positions. The asset sales being considered at firms such as Lehman and AIG (AIG, Fortune 500) will result in the loss of thousands of jobs, adding to pressure on consumer spending, which has already been hit by the free fall of house prices and weak wage growth.

While a lower fed funds rate could make money more available for domestic firms in need of cash now, it could also reduce overseas' investors interest in dollar-denominated assets, by lowering U.S. interest rates. While investors now expect to see rate cuts in the euro zone as well, hopes that the Fed would be able to hold rates steady -- and perhaps even raise them a bit next year -- played a role in feeding the dollar's recent rally. The dollar fell as low as $1.45 against the euro on Monday before recovering to $1.42.

Adding to the dollar's woes are fears that coming months will bring a series of bank failures, as the economy slows and asset prices continue to slide, adding to the tab the feds will eventually hand to taxpayers. Paulson's decision to temporarily nationalize Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) - which came after the foreign central banks that have been the biggest buyers of the firms' bonds started buying Treasury bonds instead - could end up costing hundreds of billions of dollars, and other moves - such as March's Fed-backed rescue of Bear Stearns - could carry substantial costs as well.

Fears that bailout costs will weigh on the dollar no doubt motivated Paulson this past weekend to say no taxpayer funds would be spent in support of Lehman (LEH, Fortune 500). But longtime critics of U.S. fiscal laxity - Americans, in aggregate, spend so much more than they produce that the nation ends up borrowing about $2 billion a day from foreigners as a matter of course - say Paulson decided too late to hold that line.

"By transforming $5.5 trillion of suspect mortgage-backed securities into seemingly bullet-proof Treasury bonds, the move has sparked a relief rally in the dollar as foreign investors no longer have to worry about defaults or markdowns," Peter Schiff, president of broker-dealer Euro Pacific Capital in Darien, Conn., wrote last week in response to the government's decision to nationalize Fannie and Freddie. "However, by nationalizing Freddie and Fannie, the government has merely delayed the crisis. The borrowed time will cost us dearly, as the day of reckoning will now likely involve much steeper losses for our currency."

Even after the serial crises of the past year, however, that view continues to reside well outside the mainstream, as big trading partners such as China and the oil exporters of the Middle East have shown little inclination to reduce their dollar holdings. Thus, as bad as the financial problems are in the U.S., the dollar is likely to hold at least some of its recent gains, because of the increasing weakness of the other developed economies.

"We continue to expect [a cut of] 50 bps in the fed funds rate, with the most plausible scenario occurring between Tuesday's FOMC meeting and the October meeting," writes CMC markets currency strategist Ashraf Laidi. "But we are not yet ready to pronounce the end of the dollar's upward correction, due to what may occur in European banks' ties to Lehman as well as the macroeconomic weakness in the Continent." To top of page

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