There is one overriding question that in theory concerns not only the direction of interest rates, but also the strength of the economy and the level of inflation in the United States. That question is: To what level does the value of the dollar have to decline against other currencies to be harmful to this nation? In a very roundabout way, let us look behind the mean of that question.
High real interest rates in the United States over the past several years have been a beacon, a haven to foreign money. Foreigners sell their currencies and buy dollars to invest in dollar-denominated securities, especially U.S. treasuries and other dollar assets. This has helped to make the dollar so strong. When it comes to currencies, foreigners are much more adept at investing than Americans. They realize that the enticement to buying a U.S. treasury is the high interest rate. However, they also realize that if the dollar declines significantly in value, it can wipe out the advantage derived from the high interest rate. As a result, they are quick to assess a change in the value of a currency, and if they perceive that the dollar will deteriorate in value to the point that the high-interest-rate advantage will be lost, they quickly will sell the dollar asset and place their money elsewhere.
Currently, foreign funds are helping to underwrite our federal deficit as well as having helped to aid our economic recovery. But with the economy slowing, inflation low and the monetary aggregates not growing, the Federal Reserve is in a position to foster an atmosphere in which interest rates could fall, in the hopes that the monetary aggregates and the economy would begin to grow once more. But if interest rates continue to fall, will foreign money continue to flow to the United States to buy our debt? In the past several weeks, the value of the dollar has declined as much as 7.5 percent against certain currencies. If the aggregates continue to decline, how much lower can interest rates go before foreign funds slow to a trickle or even reverse themselves?
The Fed is walking on thin ice, and knows it. Even though this is an oversimplification of the entire process, too fast a fall in interest rates could be harmful from another direction. If the dollar should decline rapidly, imports would become more costly, giving domestic producers room to raise prices, which in turn would lead to higher inflation. Higher inflation in time would lead to higher interest rates and, more than likely, a slower economy. In essence, a Catch-22 scenario seems to be taking shape. And this is another reason why it is important to reduce the budget deficit, so that we will not be dependent on foreign money. By the same token, should taxes be raised in an effort to reduce the deficit, it would lead to less spending and a slower economy.
Best of luck to the administration!