classical economics
for analysis,  forecasting
and policy design

Cut, Float Funds Rate
By Wayne Jett
© April 28, 2008

    As the Federal Open Market Committee meets again, conventional wisdom (meaning Keynesian rhetoric) frames the issue as usual: Will FOMC weaken the dollar by cutting the funds rate, or will FOMC be “resolute” and move towards higher rates and a stronger dollar? This is misguided both in the choice provided and in the analysis applied.
    The lowest value of the dollar in history experienced in 2008 is the central concern, and it is the fault of the FOMC. But the cause of the weak dollar is not “low” interest rates, and “high” rates will not strengthen the currency.
    Major financial media continue to mis-state the problem, with Scott Patterson reporting in the Wall Street Journal that: “Low interest rates undermine a currency because they give investors an incentive to park their money in securities denominated in other currencies that earn higher yields." The Journal’s editorial board rightly agonizes about the damaging effects of weak currency, but totally misapprehends the solution.
Managing Stable Currency
    The strength of the dollar may be affected on the margin by currency speculators who choose to “park” in one place or another. But the dollar’s fundamental strength is determined by demand for it as a unit of account and store of value in commercial transactions. Trust and confidence in any currency requires that its value remain stable at all times and over the long term. Stability of currency value requires a mechanism that adjusts liquidity according to changing conditions affecting demand; i.e., market willingness to invest dollars in production.
    Supply and demand for currency determines its value. This truism combined with the fact that gold has essentially unchanging intrinsic value enables a central bank (if it chooses) to manage liquidity (supply) according to changes in demand so as to keep the currency value stable. Stated simply, the central bank can keep supply in balance with demand by watching its currency’s price of gold and keeping that price stable.
Rate Manipulation Reality
    Manipulating interest rates cannot stabilize currency value. Whether interest rates are high or low, the currency may strengthen or weaken depending upon the balance of supply and demand for liquidity. Interest rates should be left to markets to set. Markets best determine who deserves credit and at what rate. Central planning manipulation of interest rates as it is presently practiced by the Federal Reserve through FOMC sets the cost of bank credit in the U. S.
    FOMC's actions since 2004 deprived small businesses (who normally must borrow from banks or other lenders rather than through the financial markets) of credit. At the same time, essentially all of the abundant liquidity furnished by FOMC through 2006 flowed to large borrowers such as hedge funds, investment banks and LBO firms. This has resulted in poor credit judgments and the resulting crisis of confidence in credit quality.
Intentional Inflation
    FOMC may or may not understand this already. Yet its members choose to weaken the dollar on the intellectual pretext that weak currency expands exports, reduces imports and shrinks the current account deficit. This use of the dollar as a weapon of trade war is spurring nationalism around the world, and understandably so, as food prices soar and hungry people riot. FOMC even theorizes that the weak dollar profits U. S. exporters but does not hurt Americans, who continue to be paid wages and buy with an unchanged “domestic” dollar. That is unadulterated sophistry.
    Assume a single universal currency is devalued by fifty percent by doubling liquidity. Surely no one will deny that prices of goods and services will double during a period of adjustment. Even in this simple scenario, wages will not adjust at the same rate as prices, so standard of living will likely suffer periodically. Now assume other currencies are added to the universe. Will their presence change the fundamental effects if the original currency is devalued by fifty percent? Surely they will not. They merely add complexity and confusion, which mirror the existing international monetary non-system.
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    FOMC creates the weak dollar purposely, though not with low interest rates. Even now, the funds rate at 2.25% remains at least 1.25% higher than where the markets would set it if it were floated. The inverted yield curve attests this, with three-month bills at 1.37% and six-month bills at 1.71%. This means small business may borrow, if at all, at a rate 1.25% higher than markets deem reasonable. That environment keeps small business from expanding, creating jobs and demand for dollars.
    FOMC should cut the funds rate to 1% or, much better, float the rate and allow the markets to set the cost of credit. Economic growth and the dollar would be far better off for having markets rather than central planners making such decisions. At the same time, FOMC should keep liquidity in check as the economy expands, moving to a dollar price of gold at a much lower level. ~