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Friday, March 14, 2008


interest rates and a dollar collapse

brilliant commentary from northern trust's paul kasriel on the tanking dollar.

After the bursting of the U.S. asset price bubble in October 1929, the Federal Reserve engaged in some aggressive reductions in its then-main policy interest rate – the New York Fed discount rate. Chart 1 shows that after raising its discount rate from 5% to 6% in August 1929, the New York Fed starting reducing its discount rate in November 1929, ultimately pushing it down to 1.50% by May 1931. The Bank of England basically shadowed the New York Fed in terms of its policy interest rate actions until the summer of 1931.

In the summer of 1931, there began to be runs on the British pound. In an effort to combat these currency attacks, the Bank of England began raising its policy interest rate, the so-called base rate. In July 1931, the Bank of England raised its base rate by 200 basis points to a level of 4.50%. This did not stop the run on the pound. On September 21, 1931, the Bank of England abandoned the gold standard but, in an attempt to forestall further raids on the pound, raised its base rate another 150 basis points that month to a level of 6.00%.

Market expectations began to develop that the Fed would follow the Bank of England in abandoning the gold standard. The United States began to experience a gold outflow. In an effort to stop this gold outflow, the New York Fed raised its discount rate a cumulative 200 basis points in two steps in October 1931 to a level of 3.50%.

So what does October 1931 have to do with current Fed policy? Well, if not a run, there has been a renewed “walk” on the dollar of late (see Chart 2). ...

But, in our opinion, what could turn a walk on the dollar into a sprint would be a decision by the Chinese and/or Saudi central banks to eliminate the pegs of their currencies to the greenback. Now, what would motivate these central banks to sever the peg? The desire to rein in their domestic inflation. In an environment in which the dollar is under downward pressure, the by-product of pegging one’s currency is higher inflation in the economy whose central bank is pegging.

... Some commentators have referred to the Chinese and Saudi pegging of their currencies to the U.S. dollar as “Bretton Woods II.” We wonder if the demise of Bretton Woods II is not close at hand. If it is, the greenback could plunge, U.S. consumer inflation could spike, and the Fed would have little choice but to stop cutting its policy interest rate, and, perhaps, even have to raise it, as it did in October 1931. As Mark Twain said, “History does not repeat itself, but it does rhyme.” We are not yet predicting this outcome, but we are listening carefully for any rhyming.

fed action on short rates would be presaged by a collapse in the bond market. beginning in 1931, the treasury market went off the reservation. bank failures became precipitate by april 1933.

the united states was providing monetary aid to britain throughout the 1920s, as documented in murray rothbard's chronicle of the depression.

should china or (to a lesser but important extent) the petrodollar recyclers refuse to subsidize the american foreign account deficit by providing a massive liquidity backstop to the united states treasury market -- as they have been for years now -- it will be 'game over' for the american economy. their price-insensitive accumulation of treasuries in an effort at currency manipulation -- keeping their own cheap vis-a-vis the dollar -- has created what many quietly see as the most massive bubble of them all. government bonds and clearly not compensating investors for inflation, and that cannot last. it will start not lasting when these countries stop trying to peg their currencies to the dollar and allow them to grow in strength.

these countries, experiencing massive inflation problems at home and receiving no help from the fed as it cuts policy rates to stimulative levels in an effort to increase dollar supply, will eventually come to believe what the economist is saying -- that they don't need the united states as an export market as badly as they once did -- and give up these pegs to resolve domestic inflationary pressures.

will that happen now? there's not much evidence for it just yet.

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