Bernanke's box

The countdown to next Tuesday is on. That day - September 18th -- the Federal Open Market Committee will meet to decide the fate of the free world. Just kidding there. But you wouldn't know it by the way Wall Street is approaching this policy meeting. Everyone is on pins and needles about what might happen. So what the heck -- why not throw my hat in the ring!

First, I think it's a lock that Fed Chairman Ben Bernanke and his band of fellow policymakers will cut interest rates. But several questions remain unresolved ...

* Will Bernanke opt for a quarter-percentage point cut or go for a bigger, 50-basis point move?

* Will the Fed’s gambit help loosen up the credit markets, allowing banks, hedge funds, and Wall Street firms to unload some of the toxic debt they’re holding?

* What will this mean for stocks? Can they just resume their run for the roses? And how about housing? Will the Fed’s move “save” that market?

My take is that the Fed will go for a 25 bp cut, and that such a cut will prove to be a disappointment for Wall Street. Why not be more aggressive? Because I think Bernanke is in a bit of a box, frankly. What's going on in the currency markets -- and the impact that’s having on other markets, like commodities -- makes it all but impossible to opt for a 50 bp reduction in the federal funds rate.

Just look at the U.S. Dollar Index. It measures the greenback’s performance against six major world currencies. The euro is the biggest weighting at 57.6%, followed by the Japanese yen (13.6%), the British pound (11.9%), the Canadian dollar (9.1%), the Swedish krona (4.2%), and the Swiss franc (3.6%).

This index has been in an absolute tailspin. It peaked out at 121 in July 2001 ... dropped below 100 in early 2003 ... knifed through 90 at the end of that year ... and just a few days ago, sank below 80. It has broken every single level of technical support except for the all time low -- 78.19 in September 1992. In other words, the dollar is staring into the financial abyss.

Two forces are driving the action:

First, the U.S. economy is weakening. The U.S. economy LOST 4,000 jobs in August, the first time that’s happened in four years. Home sales are tumbling. And consumer confidence just fell by the biggest margin since Hurricane Katrina struck in 2005. Economists are freely tossing around the “R” word -- recession -- for the first time in years.

Second, currency traders smell blood. They know the Fed is going to cave in to the Wall Street crowd and cut rates. That will make investing in short-term U.S. debt instruments less attractive vis-à-vis investing in countries with rising or stable interest rates.

Third, the dollar decline isn’t just eroding your purchasing power. It isn’t just making trips to Paris or Canberra more expensive. It’s driving up the price of all kinds of commodities ...

* Crude oil futures just topped $80 a barrel for the first time in history. Heating oil now trades for about $2.20 a gallon on the wholesale market, the highest since futures were introduced by the New York Mercantile Exchange in 1978.

* Gold futures have been screaming higher, with December gold eclipsing the $720 an ounce mark.

* The price of wheat just surged to an astronomical $9.11 a bushel, a record high on the Chicago Board of Trade.

* Soybean futures climbed above $9.43 a bushel, the highest price in more than three years.

In short, the slumping dollar is threatening to ignite a new bout of rising consumer prices. The Fed may say it focuses on “core” inflation -- inflation excluding food and energy. But with each dollar move higher in the price of oil ... and each $10 jump in the price of gold ... that stance looks more and more ridiculous in the real world.

The bottom line: How can the Fed justify LOOSENING monetary policy when the commodities markets are saying -- in no uncertain terms -- that looser monetary policy is the LAST thing we need?

Now I'm not naive. There is plenty of political pressure coming from Washington and Wall Street to cut rates aggressively. Rep. Barney Frank recently weighed in with an odd statement calling for a Fed cut, for instance. Meanwhile, several home building executives just held a meeting with Fed officials in Washington, while top mortgage company managers got together with Treasury Secretary Henry Paulson. As outsiders, we have no way of knowing what they pushed for. But I doubt these guys were asking for a rate hike.

In other words, I doubt Bernanke will do nothing. But I also don't think he can afford to go whole hog with a half-point cut. That could really pull the rug out from under the U.S. dollar -- and risk cementing longer-term inflation risks.

Fortunately, we won't have to wait much longer to find out where interest rates are headed.