The Federal Reserve Board will make its interest rate announcement in less than an hour, and it is widely expected to cut rates yet again. This would be a huge mistake. As I noted in my column, excessive Fed rate-cutting in the years after the 9/11 attacks inflated real estate prices and is partially to blame for the prediciment we find ourselves in today. The difference is, when Greenspan began his rate-cutting campaign, the dollar was still worth more than the euro, but as of this writing, a dollar will only purchase you .63 euros. That’s a stunning collapse in the value of our currency. While a strong or weak currency isn’t necessarily a good or bad thing (a weak currency can help exports, for instance), there are certain economic enviornments wherein a rapidly deteriorating currency is problematic, and I think we’re in one of those times. Given that we import most of our oil, a declining dollar will only mean that oil prices will continue to soar. Any wage gains that workers could make under the most idealized economic forecasts will be eaten up by inflation, not just in oil prices, but imports in general.
There are a few other things that trouble me about cutting rates. One is what Milton Friedman called the “fool in the shower” scenario. Just like the person who finds the shower too cold, and then overcompensates by turning the hot faucet to the max because it takes time for the water temperture to adjust, only to scold himself, economic indicators the Fed receives lag what is happening in the actual economy. We’ve now had a number of rate cuts, several other extraordinary steps by the Fed to pump liquidity into the market, and an economic stimulus package that hasn’t fully gone into effect. The Fed should wait to see how these actions work out over the next several months before pushing the panic button by lowering rates yet again and quite possibly triggering inflation.
Furthermore, there are often diminishing returns to cutting interest rates. In certain circumstances, people’s faith in the economy is erroded to the point where even very low interest rates won’t be enough to intice them into investing. And I worry that by sending the signal to the markets that the U.S. does not care about the strength of the dollar, the Fed will just be making investors more concerned about the economic outlook. Stagflation, I think, should be a realistic fear if the Fed continues down this path.
In my view, the Fed would be much better off holding rates steady, and reassuring global markets that it’s still committed to protecting the value of the dollar and fighting inflation. By taking a wait and see approach, it could always revisit this decision if the economy doesn’t respond to steps that have already been taken, especially if the dollar stabalizes.
UPDATE: The Fed lowers rates 3/4 percent. At this point, they are more concerned about a slowing economy, but also monitoring inflation. I stand by my comments above.