Posted on 08/24/2007 3:56:39 PM PDT by Toddsterpatriot
Rate increases have rarely constituted “tightening” when it comes to restoring the greenback’s value.
The Federal Reserve’s change in bias last week toward cutting the federal funds rate, along with its half-point cut in the discount rate, offers an opportunity to test the widely held belief that rate cuts weaken the dollar while exacerbating existing inflationary pressures. In truth, the opposite is typically the case, since dollar-demand shifts when the Fed acts.
Last week, the market response to the Fed’s new course was profound: Gold began a new short-term downtrend. The dollar adjusted for gold started a short-term uptrend compared with the euro adjusted for gold. The 30-year Treasury yield began a short-term downtrend. And the Russell 2000 Index — comprising small-cap companies and arguably the most sensitive equity index to monetary policy error — ended its recent short-term downtrend.
Overall, lower gold prices, a stronger dollar against the euro, lower long-term bond yields, and rising equity valuations are indisputable hallmarks of a disinflationary environment — not a resurgence of inflation.
The 2004-06 rate-hike experience, compared with last week’s Fed easing scenario, is only a small episode in the longer-term dollar response to interest rates, dating back to the beginning of the post-Bretton Woods era of the early 1970s. The dollar lost 67 percent versus gold between 1972 and 1975, despite the fact that the Fed hiked rates from 3.5 percent to 13 percent in that period. When the Fed reversed course in 1975, lowering its rate target from 13 to 4.75 percent, gold actually fell 23 percent. When the Fed raised the funds rate all the way to 14 percent in 1980, rather than strengthen, the dollar fell, driving the price of gold from $150 an ounce to an all-time-high of $892.
Just as tax increases don’t always yield commensurate revenue increases due to a downward shift in economic activity, interest-rate hikes frequently fail to enhance dollar demand. In historical terms, rate increases have rarely constituted “tightening” when it comes to restoring the greenback’s value.
A case in point came at the tail end of Alan Greenspan’s tenure as Fed chairman. Greenspan is frequently blamed for keeping the fed funds rate too low for too long, in such a way that the dollar lost value. But the dollar price of an ounce of gold tells an entirely different story. Gold hovered in the high $300s while Greenspan held the fed funds rate at 1 percent between July of 2003 and June of 2004. Gold only began to rise once the Fed began raising rates that June. After 425 basis points of rate increases, gold has risen nearly 70 percent.
The significant rally in gold during the past three years understandably caused many to call for even more significant rate increases in order to quickly defuse budding inflationary pressures. But the systematic freezing of credit during the last month has forced the Fed to ease, causing financial markets to respond to the real prospect of a lower interest-rate environment.
Targeting higher interest rates to combat inflation is very much a Keynesian concept whereby central banks seek to reduce economic activity as well as prices. Contrary to current Fed objectives, the surest way to decrease dollar demand and ultimately cause a net excess of dollar liquidity that would spark new inflationary pressures would be to target the economy for slower growth with higher interest rates.
Looking ahead to September’s Fed meeting, if the FOMC lowers the funds target, media accounts will suggest a looser stance on the part of policymakers, while an increase will be described as a monetary tightening. In truth, a Fed ease will point to dollar strength and a budding disinflation.
— John Tamny is editor of RealClearMarkets, and can be reached at jtamny@realclearmarkets.com. Paul Hoffmeister is chief economist at Bretton Woods Research, and can be reached at phoffmeister@brettonwoodsresearch.com.
Ping!
Not entirely sure how cutting government spending would solve the sub-prime bubble.
People scoff and think M1 and M2 are outdated but they’ve been off the charts for years. Now that the demand for the dollar is low, that may produce a higher dollar relative to the Euro. However that won’t last long. The dollar is still going down. Down, down, down until the ChiComs agree to a reevaluation!
That would explain how the $US was at 1.34 against the $EU and is now, after the rate cut, 1.36.
Sounds familiar to me.
Overall, lower gold prices, a stronger dollar against the euro, lower long-term bond yields, and rising equity valuations are indisputable hallmarks of a disinflationary environment — not a resurgence of inflation.
Lets see if I have learned anything
So, low dollar, high dollar, who cares? The US economy is so strong it will pull the dollar up if it goes to far down and down if it goes to far up? Hang on and enjoy the ride.
And you believe those trends will continue if the fed eases on the funds rate?
And lowering rates will make this equation more favorable?
The Fed creates inflation at both extremes of the credit cycle. It creates too much money when rates are too low, and it does economic damage when rates are too high. Both results are inflationary.
“When the Fed reversed course in 1975, lowering its rate target from 13 to 4.75 percent, gold actually fell 23 percent. When the Fed raised the funds rate all the way to 14 percent in 1980, rather than strengthen, the dollar fell, driving the price of gold from $150 an ounce to an all-time-high of $892.”
I wonder about causation. Did the value of Gold change in reaction to the Fed’s moves or did the Fed change to stop dollar problems which then showed up in the price of gold?
I’ve been trying to get a handle on the value of gold versus the dollar and its abilty to predict general economic trends. First I think gold and oil are poor commodities to use since they raise and fall on other than just pure economic news. Maybe lead? I don’t know. Anyway I did some quick and dirty analysis and found gold and oil and lead seem to be closely tied.
Just an amateur economist with lots to learn.
The economy is strong because we are selling tons of stuff abroad.
Weak $$$ : strong exports :strong economy : full employment
The economic facts of the 1970’s should shoot down the widely held belief that economic growth and employment growth cause inflation. Instead, the word “stagflation” was invented and everybody maintained business as usual.
HAH!
Cut the rate when necessary. If we’re going to keep the big import industry going for a little while, the dollar must fall to equalize with foreign currencies. And eventually, America will have to get back to real work (more manufacturing).
Where was the $US when the Fed Funds rate was 1%?
Gold hovered in the high $300s while Greenspan held the fed funds rate at 1 percent between July of 2003 and June of 2004.
Hmmmmmmmmmm.
Don't tell the goldbugs or other financial illiterates.
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