Monday, March 31, 2008

Fed should reverse some of its strategies

Ronald McKinnon believes:
Illiquid financial institutions cannot effectively bid for funds by putting up suspect private bonds or loans as collateral. Unsurprisingly, there is a "flight to quality" that increases the private domestic demand for Treasuries. But this is happening at a time when the flight from the dollar in the foreign exchanges has greatly reduced their supply.

This increased demand coupled with a fall in supply helps explains why, in the midst of a U.S. credit squeeze with higher interest rates on private financial instruments, nominal interest rates on U.S. Treasury bonds have fallen to surprisingly low levels. Despite substantial ongoing U.S. price inflation of 4.3% in the consumer price index and 6.4% in the producer price index, Treasury yields are less than 1% on a three-month bill, 1.32% on a two-year note, and 3.5% on the benchmark 10-year bonds. There are even reports of effectively negative nominal yields on certain very short-term Treasurys. The real yield on Treasury Inflation Protected Securities has turned negative.

The Fed responds to the credit crunch by cutting interest rates, which would be the seemingly correct textbook strategy if the economy were closed and the foreign exchanges could be ignored. But the economy is open, and capital flies out of the country.

The best solution to the current crisis is to stop the flight from the dollar. This would be beneficial beyond relieving the drain of Treasurys and relaxing the crunch in American credit markets. Letting the dollar depreciate without any convincing action to secure its long-term value against other major currencies undermines confidence in the dollar's long-term purchasing power. It also lets the inflation genie out of the bottle, and makes a return to 1970s-style stagflation look imminent.
I disagree with his recommendation to manipulate USD exchange rates with foreign governments.

But aye, cutting interest rates could be hurting more then helping.

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