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

Includes: DBV, QQQ, SPY, UDN, UUP
by: Gary Smith

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.”