Fed Taking Some Big Risks in Boosting Interest Rates
The Federal Reserve Board’s latest increase in interest rates, aimed at heading off a resurgence of inflation, is creating major new uncertainties for the beleaguered U.S. dollar--and for the effort to reduce the outsized U.S. trade deficit.
As expected, the greenback’s value rose sharply after the Fed’s decision Aug. 9 to raise its key discount rate--the interest that it charges on loans to banks and other financial institutions. Higher interest rates in the United States make investments more attractive here and boost worldwide demand for dollars.
So strong was the impact of the Fed’s action that the dollar continued to climb Tuesday even after the Commerce Department reported a decided worsening of the U.S. trade deficit in June. Ordinarily, such bearish trade statistics would have sent the U.S. currency plummeting.
Only heavy selling of dollars in foreign exchange markets by central banks helped stem the dollar’s rise, at least temporarily, on Thursday and Friday.
The greenback has apparently breached the still-secret ceiling that the finance officials of the United States and its economic allies set at the seven-nation economic summit in Toronto last June 21. There are now clearly “some cracks,” a senior U.S. official conceded, in the intricate system that former Treasury Secretary James A. Baker III and U.S. trading partners have put in place to coordinate policies and stabilize the dollar.
Fed Shifts Attention
More important, the Fed now faces a far more difficult trade-off in its attempts to balance the need to head off inflation with that of reducing the trade deficit.
Until last spring, that choice had seemed easy. As long as inflation remained low, credit policies could stay relaxed, and the Fed could cooperate with Baker to hold down the dollar’s value. A low dollar helps the trade balance because foreign goods are more expensive here when they are bought with weak dollars and, similarly, U.S. goods can be more attractively priced abroad.
But now, with the producer price index rising at an ominous 5.7% annual rate last month, inflation is once again seen as a threat. So the Fed has been forced to shift its attention to trying to slow the overheating U.S. economy--which means pushing interest rates up further at the risk of spurring the dollar to new, higher levels.
“If the dollar rises much beyond its current levels, there will be serious questions about the adjustment in the U.S. trade balance,” said Alan J. Stoga, an international economist with Kissinger Associates, a New York consulting firm. “That’s what these trade figures were showing us this past week.”
The inherent conflict between the two goals already has split Fed policy-makers. In the recent debate over whether to raise the discount rate, the Fed’s Washington-based board of governors, which has been closely involved with the seven-nation effort to stabilize the dollar, was reluctant to raise interest rates too quickly if it meant that the dollar would rise.
But the presidents of the Fed’s 12 regional banks, who are not as concerned as the Fed’s governors about Washington’s agreements with other nations’ finance ministries, demanded that the central bank alter its stance to concentrate on the domestic inflation problem. The regional bank presidents won on that round.
Deficit Mostly Lower
Although the dollar has been rising since January, its impact on the trade picture has been relatively modest so far.
The greenback has risen 20% since January against the West German mark, 10% against the Japanese yen and 7% on an index that reflects the volume of U.S. trade with each of its major economic partners.
Meanwhile, the trade deficit had been edging mostly lower until June. That month’s $12.5-billion deficit was the second-highest such figure this year but lower than any monthly deficit for last year.
What’s more, U.S. officials are betting that since foreign manufacturers had not yet raised their prices sufficiently to reflect the full impact of the dollar’s earlier decline, they will not cut prices quickly now to take advantage of the greenback’s recent rebound.
Overheated Economy
At the same time, while American exporters may lose some sales as a result of the dollar’s rise, they will probably reap higher earnings from what they do sell. So, for a while at least, consequences of the rising dollar may prove to be a wash.
Finally, the danger to the trade fight may be offset if the Fed’s new, tighter money and credit policies succeed in cooling domestic consumption. Part of the reason that the U.S. trade deficit worsened in June was that the economy was so overheated that the nation began consuming a lot more than it was able to produce. If consumption at home slows, Americans will buy fewer imports.
‘Raise Recession Risk’
Still, if the dollar continues to edge up, the Fed will find it increasingly difficult to manage the trade problem. Not only will higher interest rates here push the dollar’s value up, but the currency situation will be worsened by increased sluggishness of the West German economy, which is already translating into a weaker mark.
Until recently, West Germany’s central bank has raised interest rates in step with increases by the Fed in the United States.
Kissinger Associates’ Stoga warned of “a whole new interest-rate structure” worldwide that would “undercut economic growth and raise the risk of global recession.”
