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Fed cuts but faces dilemma

The US Federal Reserve’s decision to slash the funds rate by 50 basis points has been welcomed but fund managers warn the cuts are only likely to b a temporary measure due to inflation concerns.

The funds rate was cut to 4.75 per cent last week and the discount rate was also cut by 50 basis points to 5.25 per cent. The reductions were higher than expected and the S&P 500 responded with its best one day performance since March 2003, rallying by 2.9 per cent.

But the dollar hit a record low of $1.38 against the euro while longer-dated US Treasuries fell after a 0.2 per cent rise in core inflation in August. Gold hit a 28-year high at $726.95 a troy ounce.

Fund managers are revising down their US growth expectations and many warn that rates will come back up in the coming months with the economy facing inflationary pressures and the Fed keen to avoid cheaper liquidity sparking another bubble.

Invesco Perpetual chief economist John Greenwood says: “The Fed now faces an acute dilemma. If confidence returns to the credit markets in the weeks and months ahead and money and credit growth show signs of surging again, the Fed must be prepared to remove yesterday’s rate cuts if it is to avoid laying the foundations the groundwork for yet another bubble or bout of inflation.

“The rise in the price of gold and the fall in the dollar are early warning signals of this risk.”

Scottish Widows Investment Partnership chief economist Richard DingwallSmith says: “”Our view is that the US economy will experience some further quarters of sub-trend growth but will not fall into outright recession. Indeed, by the latter part of 2008, the worst of the housing market problems may be in the past and the economy should be starting to pick up pace again.

“As a result, we think that it is probable that the Federal Reserve will begin to tighten policy again on worries about inflation, with the funds rate moving back up towards 5 per cent by the end of 2008.”

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