Comment 17: The Logic behind the Interest Rates (March 10, 2005)

The Federal Reserve System of The United States of America (FED) has been raising short term interest rates in a measured manner since the middle of 2004 under the pretence to damp the risk of inflation. However, in the monthly reported inflation statistics there is no sign of any pending inflation threat. The long term interest rates is moving sideways during this period of rising short term interest rates, implying that the financial market is not anticipating any significant increase in the inflation rate as far as the eye can see. Many are thus confused about the whole picture of interest rate environment. Why does FED insist on raising short term interest rates in spite of the absence of any inflation threat? Why the long term interest rates do not move up in tandem with the short term interest rates? Once we understand the ins and outs of the current global economic environment, we will see the clear logic behind the disparate movements of the short term and the long term interest rates. In a simple phrase, the behavior of the interest rates is just reflecting the value of Dollar and the run away trade deficit of The United States of America.

We have been claiming persistently that the robust economic growth of America in the globalization age is due to the wanton expansion of personal consumption. The rapid expansion of consumption in America is the direct result of the runaway trade deficit. The runaway trade deficit, in turn, is due to the overly inflated value of US Dollar. Up to the middle of 2004, the inflated Dollar is supported by the massive dollar buying operations of the governments of Pacific Rim countries. However, the last episode of such dollar buying has shocked economic observers. In the span of 10 months, from the middle of 2003 to the spring of 2004, Japanese Government alone has bought 380 billion dollars just to prevent the collapse of Dollar against Japnese Yen. If adding the amount of dollars bought by the governments of China, Taiwan, South Korea, Hong Kong and Singapore, the total sum will surpass 700 billion dollars. It is also during that dollar buying frenzy, the first public skepticism has been voiced in Japan in a rather bizarre fashion. An adult comic strip (called "manga" in Japanese) has portrayed the dollar buying operation as a conspiracy of America to keep Japan poor and America rich. The "mango" has caught Japanese public's attention and has forced the minister of finance to openly deny the existence of such a conspiracy in front of the members of Japanese Diet (see article No.8 on this website for the account of this episode). When the next wave of dollar selling comes, it is certain that Pacific Rim countries need to buy up more than one trillion dollars in order to avoid a total collapse of Dollar. Whether or not such a massive dollar buying operation is politically feasible becomes naturally the biggest worry to all that are concerned about the matter. Though FED is officially pushing a rosy view that such a total collapse of Dollar will only correct US trade imbalance but will not induce any serious economic hardship, it is obvious that FED does not dare to test its own rosy senario by letting Dollar collapse in the next wave of dollar selling. Thus it becomes essential to postpone the onset of the next dollar selling frenzy that is sure to come. Then what can be done to prevent an outright Dollar collapse? For US Government to buy up those unwanted dollars is simply not possible, since in order to buy those dollars US Government needs to pay for them with Euros, Yens, Yuans, Taiwan Dollars, Korean Wons, and Hong Kong Dollars that US Goverment is not able to print. Only method left to support Dollar and not let it to test dangerous break-points is for FED to raise short term interest rates, and that is exactly what FED is doing since the middle of 2004. The logic behind this approach is that the rising short term interest rates in America will keep Dollar to move sideways within a band. If Dollar tests the lower limit of the band, then Pacific Rim governments, like Japanese Government, will come in with a moderate dollar buying operation to push Dollar back into the band. The amount of dollars needed to be bought in this scheme will be much less than the case if FED does not raise short term interest rates. Thus the day of reckoning of Dollar can be postponed.

Long term interest rates move according to inflation outlooks. In the past FED raised short term interest rates only to combat the real inflation threats. That is why the long term interest rates have always followed the raising short term interest rates and have moved up accordingly. However, this time the short term interest rates are raised to support Dollar. When Dollar is suspended at an inflated level, America continues to run larger and larger trade deficits. Running large trade deficits is like importing deflation. That is why America's inflation rate has been kept at a very low level in spite of run away consumption, and thus there is no reason for the long term interest rates to make any significant move. This means that the yield curve will flatten out more and more as the short term interest rates rise.

The current approach to use rising short term interest rates to support Dollar has its limits. For the next year or so this measured rise will bring short term interest rates to the range of about 5%, the so called "neutral" zone. As Dollar is suspended at this highly inflated level, America's trade deficits will continue to explode, and thus the selling pressure of Dollar will build up continuously. This means that FED must keep raising short term interest rates beyond the "neutral" zone for a period as far as the eye can see in order to prevent Dollar to collapse. What is FED going to tell American people about the need to raise short term interest rates beyond 5% level without any visible inflation risk? There is already a movement in America to force FED to target inflation rate. The motivation of this movement is obvious. If FED is forced to target inflation rate, then FED cannot raise short term interest rates if there is no inflation! Even if FED concedes at that time that the reason to raise short term interest rates is not to fight inflation but to support Dollar, the critics of FED will use FED's own words to attack FED. They will say that to let Dollar collapse is a win-win strategy. Since on one hand the cllapse of Dollar will wipe out America's trade deficit and bring jobs back to America without significant economic pain as FED itself is claiming, and on the other hand the collapse of Dollar will make the rise of short term interest rates unnecessary; also the collapse of Dollar will finally release the Pacific Rim countries from the bondage of complusive dollar buying. Is the collapse of Dollar really so benign as FED is claiming? We totally disagree with FED about this point. We believe that when Dollar finally collapses, an economic tsunami will be triggered and will wipe out the global economy, but the discussion of this critical issue will be defered to another writing at another date.

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