Straight Angle™: Dollar, Oil and Fed
Tuesday, November 06, 2007

Dollar, Oil and Fed 

I know this comes a little late in the day, a full week after the Fed cut the interest rate by 0.25 basis points. But, that doesn't diminish the effect that would have on most things that concern many of us. Fed had already cut the interest rate by 0.5 basis points earlier. That cut was ostensibly to ease the pressure on the banking industry, inter alia the credit situation.

Now, what exactly is this Interest rate cut? This is interest rate at which the Fed lends to other banks. When this interest rate is cut, banks can avail more as loan from Fed, as the cost of the money reduces- which in simple terms enable them to repay their debts (in terms of deposits and other liabilities)- this is basically borrowing to pay off other borrowing- but since borrowing from Fed has a lesser interest rate, banks borrow from Fed and meet their obligations.

There is a case being made that, due to this interest rate cut, consumers get cheap loans. I doubt whether this interest rate cut would be eventually passed on to the consumers- I mean the retail consumer. Let us see why.

When the Fed cuts the interest rate, banks take more loan from the Fed and channel that extra cash into the retail market in terms of more loans. This is made possible because, once the banks get the loan from Fed, though the amount is a liability for the bank, it would simultaneously be classified as an asset, since this is cash in hand. Now, with this asset in hand, banks make more loans with this backing- it is like making a loan with debt- but not just a portion of the loan that it had got from Fed- but usually a multiple of that amount. With such a scenario, banks have more incentives to keep the retail lending rate at the same rates rather than cutting it. With the retail lending rates anyways tied to the individuals credit rating, the rates can be justified with arbitrary reasons. This is all the more interesting, because the Fed lending rate is a constant for all banks irrespective of the banks own credit rating- it would be the same for a splurging bank as well as a more prudent bank- so eventually, prudent banks would be loosing out to a splurging bank.

With so much money flooding the system, inflation increases. It is a basic principle of economics- when the money supply increases, it increases the purchasing power of people and so prices increase in response to the increased purchasing power. When the prices increase, this would more or less wipe out the perceived richness we get with increased money supply. What we bought for 1$ earlier, when we had 2$, would cost 2$, when we have 4$ in hand, due to the increase in money supply as a result of the rate cut. But to be true, this is not always the case. Government has many avenues to control this rise in price. As China recently did with the price control of Oil, to tame the inflation menace, Sovereign governments have multitude of controls to make it seem good- but someone somewhere had to necessarily take a hit- in the price control scenario, it would be the Government- the Government has measures to take care of this too- by way of increased tax revenues due to the increase in money supply- with increasing wages, tax revenues too increase- the ordinary consumers end up paying twice- once in the form of increasing cost of living and the other in the form of increased tax payments.

With this in mind, look at the oil prices! Dollar is primarily backed by oil. Which means, whenever there is a turbulence in the dollar rates, it makes more sense the Oil market too undergoes the same turbulence. There should be no surprise that Oil rate increases at this time. With the dollar supply increased, it is obvious that anything that is marked in terms of dollars will definitely get costlier. I wouldn't be surprised, if there is a further increase in the Oil markets.

With dollar running in its long time low with increasing pressure from Euro and other currencies- Dollar wouldn't be a safe bet in the long run.

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Blogger Preethika said...

Very good template and neatly presented works!!!

11/07/2007 10:33 PM  
Blogger Krish said...

@Preethika: Thanks for the visit and comment. Hope

11/09/2007 2:57 PM  
Blogger Mouly said...

Krish, there is lot more to rate cut than what you have stated. Moreover - "This is interest rate at which the Fed lends to other banks" - Fed rate is not the rate at which Fed lends money to banks (infact Fed doesnt lend money at all, except to Federal /state govt). Fed rate is otherwise called interbank rate, the rate at which banks borrows from other banks in a short term. This rate has a controlling effect because in effect the banks lending rate also goes down automatically(almost all the time the banks lending rates are pegged at a percentage point over the interbank rate or fed rate). This way, more money is pushed to business/economy in the hope of reviving the growth. This is a traditional measure(cutting the rate) during a recessionary period. The opposite happens when the economy is booming ahead (you could have noticed similar fed hikes some 4-5yrs ago).
PS: Anyways I didnt read after midpoint of the post :)

11/17/2007 9:14 AM  
Blogger techie said...

"Fed rate" is the overnight lending rate, controlled by a wing called FOMC. Every bank (fdic insured) is required to maintain a minimum balance at the Federal reserve. Any lending comes from this pool of money , which means that an increase/decrease in Fed rate has a ninverse effect on money circulated by the banks in the retail market.

Therefore, a college student or a home buyer would be directly/indirectly be able to borrow more, by a rate decrease and vice versa. Institutions and corporations will be affected by a greater degree than a common man.

11/29/2007 6:57 PM  

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