Plunging dollar limits Fed's scope for US rate cut

The recent fall in the dollar will prevent the US Federal Reserve from cutting rates by a half-point tomorrow but will not stop a smaller cut to bolster the economy, analysts believe.

The Fed's board must set rates against a background of growing gloom about the US economic outlook.

The dollar has fallen by 4 per cent against a basket of currencies over the last month, a move that might cause inflation. It was undermined by fears that a recovery was not around the corner, and by the International Monetary Fund's warning of a dollar collapse.

Mike Lenhoff, chief portfolio strategist at UK fund manager Gerrard, said with unemployment falling, a falling dollar was unlikely to stir up inflation. "A limited slide in the dollar is unlikely to prevent the Fed from lowering interest rates," he said. "But it is doubtful the Fed will go for a full 50 basis points."

The exchange rate would become more of a live issue if there were a "dollar crash scenario", says Daragh Maher at ING Barings. He said: "Growing dollar weakness will be a concern, particularly if it builds sufficiently to risk a potentially catastrophic dollar crash."

Writing in today's Independent, Stephen King, managing director economics at HSBC, says that – on one interpretation – a "modest" fall in the dollar would be a boon for the world economy. "A combination of a modestly lower dollar, more cuts in US interest rates and a more aggressive approach to monetary policy from the [European Central Bank] would be a net plus for the world economy over the next 12 months," he says. But Mr King warns that the fundamentals of the US economy pointed to a risk of an "amazing free-fall".

Most analysts are forecasting the Fed will order a cut in rates of a quarter-point to 3.5 per cent, taking the easing in monetary policy to a full three percentage points.

Although recent economic data have been mixed, the publication of the Fed's "Beige Book" survey of regional economic growth sparked fears that the recovery may be more elusive that previously thought, and this proved a drag on the dollar. Trade figures on Friday showed that exports and imports fell to levels not seen since early last year, prompting fears that second-quarter GDP growth would be revised down to zero or worse.

The other key figures were retail sales, industrial production, housing starts, Michigan confidence index and inflation, which all came in strong. However, the Philadelphia Fed survey was weaker than forecast.

Stephen Lewis, chief economist at Monument Derivatives, said that since some on the Fed had argued against the half-point cut in May, it would need a change of heart among that group to sanction such a move.

Stephen King, page 13