The biggest event risk this week is undoubtedly the Federal Reserve’s monetary policy decision on Wednesday. Now more than ever, the Fed’s decision could turnaround the currency and equity markets. Since the last interest rate cut by the central bank on October 8th, the dollar has rallied more than 8 percent and the Dow Jones Industrial Average has fallen by more than 10 percent. The Fed’s half point rate cut at the time was a part of a coordinated effort with central banks from around the world including the ECB, the Bank of Canada, the Bank of England and the Swiss National Bank. With US interest rates now at 1.50 percent, the Fed will need to start rationing rate cuts going forward unless they want to take interest rates to zero.

Going into the FOMC meeting, economists can’t seem to agree on how much the Federal Reserve will cut interest rates. Of the 64 economists surveyed by Bloomberg:

53 percent expect a 50bp rate cut
26.5 percent expect a 25bp cut
19 percent expect interest rates to remain unchanged
1 lone economist or 1.5 percent of the people polled expect a 75bp rate cut.

Fed Funds traders appear to be more optimistic as they have already priced in 50bp of easing for Wednesday with a 32 percent chance of a 75bp rate cut.

The recent strength of the US dollar will add pressure on the Federal Reserve to make a larger interest rate cut but everyone needs to realize that the rate cut by the Fed this week will not be their last. Even though the national average of gasoline prices has fallen 35 percent, layoffs continue to rise. If GM and Chrysler are forced to cut back or worse, pushed into bankruptcy, unemployment will continue to grow. The US economy is expected to get worse before it gets better and the Federal Reserve will not want to back themselves into a corner quite yet; a larger rate cut on Wednesday would give them less room to cut interest rates in December.

Here are the 3 most likely outcomes for Wednesday’s monetary policy decision:

Coordinated Rate Cut by the Fed, ECB and BoE (Dollar Bearish)

The best and most effective option for the Federal Reserve would be to coordinate a rate cut with the European Central Bank and the Bank of England. All 3 central banks would get the most bang for their buck by working together. Given Monday’s comments by ECB President Trichet about cutting interest rates again in November, he may not be opposed to making the rate cut one week earlier. The Times of London has also indicated that the BoE is under pressure to cut rates as well. This measure of solidarity would send a strong message to investors and at the same time not require the Federal Reserve to take interest rates below 1.00 percent, leaving them little room to cut interest rates later. A coordinated rate cut to should be bullish for the global equity markets and bearish for the US dollar.

Independent 50bp Rate Cut from the Fed (Dollar Neutral)

Although a coordinated rate cut is the most effective option for the currency market, it may not be the most likely option because for whatever reasons, the ECB and the BoE may be opposed to coordinated intervention. Since an independent rate cut by the Federal Reserve is exactly what the market expects, the impact on the US dollar should be limited. The key will be the tone of the FOMC statement.

25bp Rate Cut (Dollar Bullish)

A 25bp rate cut will be a big disappointment to both the currency and equity markets. Given the degree of risk aversion and fear, we do not believe that Bernanke will risk the consequences of a disappointment since it could trigger another round of selling for stocks and high yielding currencies. In this type of market environment where investors are becoming immune to new measures taken by the US Treasury and the Federal Reserve, it pays to over deliver.

75bp Not a Viable Option - Too Close to ZIRP

Even though Fed Funds traders are pricing in a respectable chance of a 75bp rate cut, we do not believe that this will happen because it is too close to zero. Zero interest rates come with a host of problems. If the economy worsens substantially despite zero interest rates, we will be experiencing a world of problems in rejuvenating growth. This situation can best be exhibited by the Japanese recession that ensued during much of the nineties. With interest rates at nearly zero levels, the BoJ found itself unable to stimulate growth with no policy tools available at its disposal. During this time the BoJ was forced to implement newly devised policy measures that had little if any effect on promoting growth. At the same time, a zero interest rate is also inflationary.

Although we believe that a coordinated rate cut would be the best option for the Federal Reserve if they want a good chance at stabilizing the markets, the fact that Trichet talked about cutting interest rates on November 6th specifically suggests that it may not be an option that he is seriously considering. If the central banks can work together, Wednesday’s rate decision could turn around the currency markets, but if they choose to respond with fractured rate cuts, risk aversion could remain a problem.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.