Perhaps it’s time for the US Federal Reserve and the American public to choose their evil.

Cutting interest rates may or may not ease the credit contraction (it hasn’t so far) but in turn means a lower US dollar, rising commodity prices (especially oil) and lower retail sales and consumption.

No more rate cuts would mean a steadying of the US dollar (perhaps a small rise), an attack on inflation and an acceptance that the US economy is on its way to the bottom and should be allowed to find its way there.

Next week looms as the week to make that decision with the Fed to meet on March 18: the debate is whether to cut rates by 0.50% or 0.75%. After Tuesday’s $US200 billion Treasury securities deal 0.50% is the tip.

The US (and many other countries) will have to decide what is worse: the prospects of a credit squeeze forcing a complete shutdown of markets, or the inflationary undermining of economic activity from the sliding dollar and the rising cost of living.

Figures out on Friday night will probably tell us that US Consumer Price Inflation last month rose on January’s 4.3% annual rate. Forget the core versus headline rate: rising food and energy costs are part of core inflation now.

The markets understand the dilemma. Yesterday the Dow was down, the US dollar slid past 1.55 to the euro, oil rose over $US110 a barrel, wheat jumped back past $US12 a bushell, and yields on US Government securities fell as investors went back to a bit of safety as two more hedge funds reported problems.

The greenback’s slide has effectively underwritten a bubble in commodity prices, especially oil. It’s an easy punt to use stronger euros to buy US priced commodities and wait for the slide because the market knows the Fed will continue to cut interest rates, which in turn generates an automatic gain.

In the end the financial system should be the main focus for regulators: if it stops functioning then more people will be impacted that if the US economy slides into recession. The Fed will be asking how much a weakening dollar hurts the financial system (and the economy) and whether it will even matter if it stops cutting interest rates.

If the Fed cuts to 2.5% next week, it will take the cuts to 2.75% since last September. And so far they have done nothing.

To tell the world they’re stopping the rate cuts to concentrate on inflation and the credit crisis, and the economy can slide, would be an interesting approach. It would also send the message that the easy games in commodities are over.

Meanwhile, Wall Street banks are about to be put on notice to improve capital management and a range of other processes. Bloomberg reports that the results of a review of bank capital and lending processes from the President’s Working Group on Financial Markets could be released tonight, including proposals to strengthen supervision of banks’ capital, amid concern they failed to protect against the risks they took investing in subprime securities. Bloomberg says that blame for the debacle will be spread among bank supervisors, ratings companies and large banks and securities companies.

Peter Fray

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