Today's Lesson: Why the Fed Raised Its Rates in 1931

In Northern Trust's latest Global Economic Research [.pdf], Paul Kasriel gives us a history lesson, recalling the sharp interest rate cuts by both the U.S. Federal Reserve and the Bank of England from late 1929 until mid-1931. There followed a run on the pound, which the Bank of England countered by sharply re-raising its rates and then abandoning the Gold Standard in September 1931. Similarly pressured, and facing a heavy gold outflow, the Fed raised its rates. Kasriel explained the need for the history lesson: so that we can understand why the Fed's current interest rate policy could similarly be "constrained by developments in the foreign exchange markets."

While there may be no run on the currency today, Kasriel does recognize a "walk on the dollar," and, in the light of other major central bankers' expressed reluctance to lower their interest rates further, continued reductions by the Fed, he suggests, would put downward pressure on the greenback.

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.

The inflation mechanics are as follows. The pegging central bank has to buy U.S. dollars in the foreign exchange market in order to prevent the dollar from falling against its currency. The dollar-buying central bank purchases dollar with its own currency. The dollar-buying central bank gets its own currency the same way all central banks get their own currency – it figuratively “prints” it. The dollar-purchasing central bank therefore floods its economy with its own base money, resulting in inflation – inflation in the prices of goods/services and inflation in the prices of assets.

What would happen, Kasriel ponders, if the Chinese and Saudis abandoned the pegging of their currencies to the U.S. dollar:

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.”

Comments

[Skjellifetti:]

China is sterilizing the dollars by issuing enough bonds to soak up the yuan they are printing to buy the dollars that are flooding into their economy through their trade imbalance with the U.S.

While Herbert Stein has reminded us that things that cannot go on forever, don't, it is not clear to me why China is importing inflation given the sterilization policy and the fact that they have been (too!) slowly re-valuing the yuan in recent years.

2008 Mar 26 02:43 PM

[flow5:]

A quarter century ago US oil imports accounted for the US trade deficit. The concerns expressed over the years about "energy dependence" accustomed Americans to think of trade problems only in terms of oil. The desire to gain "energy independence" has led to such foolish policies as subsidies for ethanol, the main effect of which is to drive up food prices and further ravage the poor.

Today oil imports comprise a small part of the US trade deficit. During the decades when Americans were fixated on "the energy deficit," the US became three to four times more dependent on foreign made manufactures. America's trade deficit in manufactured goods, including advanced technology products, DWARFS the US energy deficit.

For example, the US trade deficit with China is more than twice the size of the US trade deficit with OPEC.

The US deficit with Japan is about the size of the US deficit with OPEC.

With an overall US trade deficit of more than $800 billion, the deficit with OPEC only comprises one-eighth --- Paul Craig Roberts

2008 Mar 26 02:55 PM

[flow5:]

There are different degrees of hyperinflation. Whether the dollar plummets today, or steadily declines, will not change deep-rooted stagflation. Stagflation is going to be an enduring feature on our landscape.

2008 Mar 26 02:58 PM

[low:]

You know, I was just revisiting 911 at YouTube and the most preposterous thought entered my mind. Not to upset anyone or validate the claims of Conspiracy Theorists but. It is rather intriguing the comparisons which can be made to the state of the US$ alonside the fate of those two towers.

It occurs to me that whether malevolently planned or
not, that mortgage/credit mess plays so well into the
hands of an adversary that it's an almost absurd idea
to fathom that it must have occured to none of us we
could be slitting our own throats.

Not too long ago I commented on another article
regarding the manipulation of the price of oil and gold, now I admit my assessment could have been
in error. I acknowledge this fas paux because I realize that the degree of manipulation required
to parlay the combined gold reserves of the global community into a sufficient amount to offset their monetary deficits, could not possibly go unnoticed.

I can only hope I can make the same apology about
the US$ once all the dust has settled!

2008 Mar 26 08:28 PM

[Jason Mark:]

If the dollar is to rise in value a combination of two things must happen. Other countries begin investing more heavily in the U.S. supporting economic growth while the price of money goes up in effect making it more expensive to borrow. I know lowering interest rates makes borrowing money more attractive, but it doesn't change WHO should be borrowing. There hasn't been enough time between Greenspan's cuts and the current cuts for the dollar to have had time to recover. We've gone from one bubble to the next. Remember also that higher interest rates make money more expensive which adds value and higher interest rates provide greater returns on interest baring accounts which makes those accounts more valuable. Lower interest rates to the opposite on both counts.

2008 Mar 26 09:17 PM