Fed has lost control over interest rates

Jubak's Journal12/5/2006 12:00 AM ET

By Jim Jubak

Squeezed by a possible recession and a troubled currency, the Federal Reserve will have to side with the world's bankers and the billions of dollars they hold.

Last week the world called the tune, and the U.S. dollar danced.

The dollar's tumble and Federal Reserve Chairman Ben Bernanke's attempts to placate overseas investors are the clearest signs to date that the foreign investors who finance the huge U.S. trade deficit have gained significant control over the U.S. economy.

A few more weeks like that, and it will be clear to everyone outside of Washington that the Fed has lost control over U.S. interest rates.

Here's what happened:

On Nov. 28, as the dollar edged toward freefall against the euro, hitting a 20-month low against that currency and plunging below key support prices in the currency markets, Bernanke got up on the ol' soapbox to say that inflation was still "uncomfortably high," growth in the economy was solid and the Fed's next decision would be whether to raise interest rates again.

That came as a big surprise to financial markets that were anticipating a cut in interest rates, perhaps as early as the first half of 2007. Just that morning the markets had, in fact, received confirmation of their view when durable-goods orders, an important gauge of the health of the economy, fell by 8.3%. That's the biggest drop since July 2000 and well above the 5% decline Wall Street had expected.

Bernanke's words didn't stop the carnage: Without some proof that the economy was as strong as the Fed said it was, the markets simply tossed off the Fed chairman's comments as a transparent attempt to talk up the dollar. It didn't help that new Treasury Secretary Henry Paulson was out -- predictably -- trying to talk up the dollar at the same time.

The dollar didn't stabilize until the next day, when revised figures on third-quarter gross domestic product showed the economy growing by 2.2%, rather than the 1.6% rate in earlier data. That was stronger growth than the 1.8% that financial markets had expected and provided enough credibility to Bernanke's remarks to push the dollar up 0.3% for the day.

Why the dollar isn't out of the woods

The dollar faces three big problems, none likely to go away quickly:

• There's that whopping U.S. trade deficit. Even though lower oil prices led to a drop in the September trade deficit to a mere $64 billion from the August record of $69 billion, it is on track to break $750 billion this year. That deficit has to be balanced by cash flows from overseas investors who provide the extra money that we spend to buy foreign goods and services. This puts more dollars in the hands of overseas investors and central banks who are already worried about what to do with the dollars they hold.
• Second, there's the slowing of the U.S. economy in 2007. Yes, the revised third-quarter GDP growth at 2.2% was good news, but the economy is still in slowdown mode; second-quarter growth was 2.6%, after all. There's a good likelihood that U.S. growth will lag growth in Europe and Japan for at least the first half of 2007.

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• Third, U.S. interest rates aren't headed any higher at a time when the European Central Bank and the Bank of Japan are still raising rates. That will lower the yield gap between U.S. interest rates and those in Europe and Japan, and as a result, the price of U.S. notes and bonds is likely to fall, while those issued in euros and yen climb.

Put it all together -- a global dollar glut, a slowing U.S. economy and rising euro and yen yields -- and pressure on the dollar is likely to continue well into 2007. In my opinion, the dollar will stay under pressure until Japan and Europe signal a rate pause, and until the U.S. economy starts to re-accelerate or those of Japan and Europe start to slow.

The long-term implication for interest rates

This week's stumping for a stronger dollar by the Federal Reserve and the Treasury marks a shift of priority for U.S. monetary authorities. Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer not to tank the economy. But Bernanke and company know that the tough choice must be made, managing the dollar is more important at this point than managing inflation or growth.

That's because the huge piles of dollars sitting in the vaults of the central banks of China, Russia, Japan, the OPEC countries and the European Union are large enough that they make overseas bankers nervous. When you hold 700 billion U.S. dollars in reserve (out of a total $1 trillion in foreign-exchange reserves), as the Chinese do, for example, every penny decline in the value of the U.S. dollar makes you nervous, since it represents a drop of $7 billion in the value of your dollar holdings.Sure, there are lots of good reasons to hold dollars and dollar-denominated investments. The yields are higher on U.S. Treasurys and the notes of agencies such as Fannie Mae (FNM, news, msgs). The markets are deeper. The euro is still a relatively untested currency and Japan, the home of the yen, is still crawling, maybe, out of a decade-plus of deflation.

And, most important of all, keeping currencies like the Chinese yuan cheap in relation to the dollar keeps Chinese goods cheap, keeps Chinese exports growing, keeps factories humming and provides new jobs for a restless Chinese population.

Patience has its limits

But that doesn't mean, if you're a central banker in Beijing, Tokyo, Moscow, Riyadh or Frankfurt, that you're willing to sit in dollars forever. Especially if it looks like the dollar will be worth less tomorrow than it is today. Already, Chinese monetary authorities have made it clear that they are putting a smaller percentage of their new foreign-exchange earnings into dollars.

That's a long way from selling dollars, and so far the Chinese are staying in dollars while looking for higher yields than Treasurys pay. But it shows that the Chinese, and the rest of the world's central bankers, are in the midst of an active review of their options.

All it would take for them to exercise one of those options and begin selling dollars would be a conviction that the drop in the dollar is no longer controlled and that the best choice in a bad situation is to sell dollars now before more damage is done to the value of those carefully acquired dollar reserves.

Edging toward the precipice

The Fed knows that the U.S. dollar can rely on the economic self-interest of our biggest trading partners, but it knows that the willingness to hold even a slowly declining dollar created by that self-interest isn't endless, and that continued U.S. trade deficits have eroded that willingness. The dollar is poised on the edge -- maybe not on the very edge but increasingly close to it -- of a very nasty negative feedback loop: a falling dollar leads to dollar selling which leads to a falling dollar which leads to more selling. Once a rush for the exits like that starts, it's hard to stop without some of the players getting badly hurt in the melee.

The U.S. Federal Reserve knows this and is, I believe, determined to head off the possibility of that kind of dollar panic. If strong words about the need for higher interest rates -- blamed on stubborn inflation rather than a global glut of dollars -- will do the trick, all well and good.

If it takes stronger medicine -- an actual increase in U.S. interest rates -- to do the trick, I think the Federal Reserve will raise interest rates, even if the economy is weaker than it would like. The cost of letting a dollar decline turn into a run on the dollar is simply too high. To the Fed, the domestic and, indeed, global damage of a run on the dollar outweighs the purely domestic costs of a period of slow or no growth.

Better now than later?

The choice is easier for the Fed than it would be for you or me. The Fed knows that, once started, the only way to end a dollar panic would be through massive increases in U.S. interest rates. Better to raise rates a little now, even if it creates unemployment and takes a bite out of stock and bond prices, than to face the need to raise rates so high later that it risks sending the U.S. economy into a recession that could be deep enough to take the rest of the global economy with it.

For the Federal Reserve, this dollar scenario moves the focus of policy away from managing domestic interest rates in order to control U.S. inflation and growth in the U.S. economy. The new focus has to be on keeping the overseas investors and bankers who hold so many of our IOUs relatively content with their massive U.S. dollar holdings.

Interest-rate cut less likely

Domestically, an interest-rate cut in 2007 is still on the table. The economy could slow enough so that such stimulus would be appropriate.

But globally, to a Fed that increasingly has its eye on the value of the U.S. dollar, I think an interest-rate cut in 2007 is on the edge of falling off the table. And if the dollar declines a bit more, that option will tumble right off the table. The Fed simply would not have the luxury of putting the domestic economy ahead of the interest of the overseas investors and banks that hold so many U.S. dollars.