Fed Hints Hike in Interest Rates to Prop Dollar

The Federal Reserve issued a guarded signal Tuesday that it is willing to prop up the sagging American dollar by allowing a rise in interest rates, which have declined substantially over the last two years.

In response, interest rates and the dollar both increased sharply.

At the same time, Treasury Secretary James A. Baker III, hinting at an attempt to halt the dollar’s slide, warned that any further plunge in the U.S. currency will cause hardships in Japan. “At some point,” Baker told the House Ways and Means Committee, “it becomes counterproductive to talk in terms of further exchange rate changes or further exchange rate adjustments.”

The Fed, opening a key secret policy-making meeting this week, failed to take action that would counteract a sharp increase in short-term interest rates in credit markets. That apparently convinced currency traders that the central bank is prepared to allow rates to rise--thereby making U.S. investments more attractive to foreigners and helping protect the dollar against further declines.

“The Fed is at the very least allowing the market to bid rates up,” said Joel Keffer, an economist at Irving Trust Co. in New York. He explained that the central bank made no effort to intervene in money markets Tuesday to prevent a rise in the federal funds rate, which measures the interest banks charge one another for overnight loans.

Yields on three-month Treasury bills rose to 5.79% from 5.70%, and the government’s key 30-year bond fell nearly $10 per $1,000 face value as its yield climbed to 7.61% from 7.52%.

Gains Against Mark

And, by the end of the day, the dollar was worth 1.8160 West German marks, sharply higher than its low for the day of 1.7920 marks. Against the Japanese yen, the dollar rose to 153.35, up from 152.15 yen at Monday’s close.

Administration officials acknowledged that Baker has proposed in private meetings with foreign finance officials establishing a system of target zones, or broad “reference ranges,” in an effort to limit the dramatic currency swings that have been common in recent weeks. Central banks eventually would intervene in the markets to prevent currencies from rising above or falling below their target zones in relation to other currencies.

In return, he is seeking agreements from Germany and Japan to stimulate their economies through tax cuts and lower interest rates. That would help reduce the U.S. trade deficit with those nations by increasing German and Japanese demand for U.S. goods.

Fails to Persuade Germans

But Baker so far has failed to persuade West German officials to accept the plan for exchange rate target zones--an approach that is also advocated by France and Japan--or won their support for measures to stimulate Germany’s stagnant economy.

So, despite strong attacks on Japan by several lawmakers, Baker generally praised Tokyo for its accommodative stance toward the United States, while implicitly warning Germany that the dollar would fall further against the mark unless Bonn accepted the need for stronger domestic growth.

“There can be little question more needs to be done to promote more rapid growth abroad,” Baker said. “The alternatives to stronger growth abroad--unacceptable levels of economic activity in the United States, or exchange rate changes greater than would otherwise be needed, or both--cannot be viewed lightly in the current international environment.”

Baker and Fed Chairman Paul A. Volcker are engaged in international economic brinkmanship, using the threat of a weaker dollar to help ward off protectionist legislation by Congress while trying to assuage foreign fears that a further plunge in the dollar would wreak havoc in Europe and Japan by suddenly undermining their export-led economies.

‘The Only Weapon’

“No one around here thinks the dollar needs to go much lower to foster an improvement in the trade deficit,” one Administration official said recently, “but it’s the only weapon we’ve got to encourage the Germans in particular to change their policies and to keep the Japanese moving in the right direction. And driving down the dollar is the only thing that Congress understands.”

Adding to the Administration’s problems is recent evidence suggesting that the German and Japanese economies are likely to remain sluggish, while the U.S. economy appears on the verge of faster growth. If that happens, the United States would continue to buy more foreign products without finding a healthy outlet for its own goods abroad, aggravating the huge trade imbalances and adding to the pressure from Congress for more protectionist measures here.

With Congress moving to pass a trade bill this year, Administration officials Tuesday urged lawmakers not to limit the President’s authority to enforce existing trade laws. Also, they vowed White House opposition to any trade bill that would establish broad import tariffs or single out specific industries for protection.