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Fed in delicate juggling act

Updated: May 3, 2013 12:14PM

Most Americans haven't noticed yet, but a supermodel certainly has the Fed figured out. When Giselle Bundchen demanded that her modeling contracts be paid in euros, not dollars, she was only expressing the truth made evident by the currency and gold markets this past week: The dollar grows more worthless by the minute.

The dollar is falling in value because there are simply too many dollars in the global marketplace as a result of our borrowings and trade deficit. Even worse, the Fed is making it less attractive to hold dollar investments by cutting interest rates.

There's an old rule in the financial markets: "Don't fight the Fed." The long period of growth in the U.S. economy for nearly 20 years is a testament to the Fed's power. But now the Fed is trapped. It must push rates lower to stimulate our economy. But it also must keep interest rates high enough to attract buyers for all our debt.

For the first time ever, Fed governors must consider not only what's good for our economy, but they must also consider the power of foreign central banks that hold our debt and finance our deficits. Even though lower interest rates would help consumers, business and the entire economy, the Fed is limited in how much it can cut short-term rates and still allow the Treasury to finance our deficits.

Another worry for the Fed: Longer-term rates are set by the bond market. If bond buyers fear the Fed will cause inflation in its effort to keep the economy out of recession, investors will sell bonds, pushing long-term rates higher.

The Fed is definitely caught in the middle. And so is the American economy and the American consumer.

Let's take a look at the possibilities so you can be prepared.

HIGHER INTEREST RATES. If the bond market pushes longer-term rates higher, consumer debt will become more expensive. Credit-card rates will stay high. Lenders will become even less forgiving of late payments. Adjustable-rate-mortgage payments will jump higher when they reset, as will home-equity-loan rates.

Prepare for those possibilities by locking in a 30-year fixed-rate mortgage now, and by paying down credit-card debt, and home-equity loans. Of course, you don't have extra money now or you wouldn't be in debt. But take a part-time job now to accumulate some extra cash, before the slowing economy squeezes the job market.

FALLING STOCK MARKET. If higher rates (and energy prices) slow the economy, that's bad news for stocks. But it doesn't mean you should sell all your stocks or mutual funds. No one can time the market. And if inflation does return because of the Fed's efforts to create liquidity, then stocks could be an important hedge against inflation.

Then again, not all stocks will benefit. Companies that import goods or materials will find profit margins squeezed while those that sell abroad (such as Coca-Cola and McDonald's) will get a boost to earnings when their foreign earnings are converted to dollars.

FALLING DOLLAR. Don't plan to travel abroad. That's the most obvious implication. But if you're trying to sell a vacation home or condo, consider putting an ad in a European paper. American real estate looks like a bargain to foreigners! Imported products will cost more, and U.S. companies will raise prices, too, in order to offset higher energy costs. Even goods from China (which ties its currency to the dollar) probably will cost more as the cost of transport rises. As noted in my July 23 column, you can hedge the falling dollar by buying mutual funds that invest in foreign currencies.

INFLATION. You'll see the impact of the falling dollar and rising prices in a rising Consumer Price Index a year from now. But inflation won't help the housing market, which will be pressured as banks sell homes acquired through foreclosure, and by higher mortgage rates.

You might have noticed some contradictions in these scenarios. The Fed is trying to get interest rates to drop, while the market might push rates higher in anticipation of inflation. The economy could fall into a recession, or maybe just stagger along with a falling dollar causing inflation.

This might be time to resurrect an old word from the 1970s -- "stagflation." That's the worst of all worlds: slow growth and rising inflation. It's a real possibility. And that's The Savage Truth.

Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.

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