Federal Reserve and Monetary Policy: Oil's Well That Ends Well

Watch the $dollar. If corporate profits suffer because of the recent strength of the $dollar AND if this forces them to begin cutting cost to meet Wall Street's expectation AND the $dollar weakens, the Federal Reserve will stop. If corporate profit suffer, but margins are stable AND the $dollar breaks old levels (example: 117 Euro) then the Federal Reserve will continue its course of rate hikes until the $dollar is at par with respect to other major currencies.

Remember, a few hedge funds got into trouble with a bad strategy with regards to the GM and Ford's stock/bond hedge. It is possible that the recent and rapid strength of the $dollar has also blown other strategies. The Federal Reserve must continue its “measure pace”.

The price of oil will determine if the FOMC makes an other move on short term interest rate in its August meeting. The key to understanding this is to look at the $dollar index (see: Monthly $Dollar Index). When oil first approached the $55 range, the index was around 86 (June, July and Aug of 2004). The summer soft patch. The index was ranging in the low 80's during the first half of this year. It is now at 86. Turn your attention to the reasons that were given for the price of oil last year: the weak dollar along with global event risk. The excuse given during the first half of this year is based on capacity concerns. Now the excuses are again global event risk and capacity concerns. Notice what is missing, its the weak $dollar (as measured by the index). Let's add in a probable revaluation of the Yuan this summer(?) China pegged its currency lower than the US $dollar, which in turned made $dollar denominated commodities MORE expensive for the Chinese. If China revalues the Yuan by the rumored 10%, this in effect, will be a sharp drop of commodity prices in China. If this drop in prices reaches the Chinese consumers, then it becomes a certainty that the demand for commodities, like oil, will INCREASE (increase in demand). This becomes a problem of price stability for the Federal Reserve.