Politics & Policy

Too Much Paper of All Colors and Sizes

Central banks do their job when they make currencies valuable through the credibility of their commitment to stability.

An article in last week’s Wall Street Journal talked about rising interest rates around the world, and the likelihood that the rate increases would strengthen the currencies of the countries pursuing them. While the Journal’s assumption might make intuitive sense, the evidence suggests that the opposite is occurring.

 

About the present currency situation, economist Reuven Brenner has said, “There is too much paper of all colors and sizes floating around.” Brenner notes that gold is “an ‘anchor’ for pricing, independent of all government and all central bank policy,” and as such, it serves as a useful signal of currency strength/weakness. Measured in gold, currencies around the world are losing value despite the interest-rate hikes.

 

Australia has moved its cash rate from 5.25 percent in March of 2005 to 6 percent today.  Despite this supposed tightness, the price of gold in Aussie dollars has risen 46 percent over the time in question. Neighboring New Zealand began hiking rates in January of 2004 from 5 percent to 7.25 percent today. The price of gold in New Zealand dollars has risen 53 percent over that timeframe.

 

The European Central Bank (ECB) has moved its target rate 75 basis points higher since January of this year, yet the price of gold in euros has risen 19 percent. Closer to home, much has been said about the Canadian dollar’s strength versus that of the U.S. dollar, but in terms of gold, its currency has weakened — gold having risen 27 percent despite 225 basis points of rate hikes since April of 2004.

 

The above-mentioned Journal article noted that the U.S. “dollar tends to climb when the Fed is pushing up rates,” but as is well known now, the dollar/gold price has risen over 50 percent since the Fed began a series of 17 rate hikes in June of 2004. And despite a “red” terror alert from the U.S. authorities on August 10, not to mention a U.N. cease-fire resolution not long after (one that was seen by many to have strengthened Hezbollah and Iran), gold is off 5 percent in dollar terms since the Fed decided to hold its target rate at 5.25 percent on August 8.

 

That rate hikes are often inimical to currency strength really isn’t that surprising. In raising rates, central banks seek to lower demand for money. From the Fed’s output-gap perspective, this makes sense: If people demand less money they’ll spend less, the economy will shrink, and inflation pressures will fall. But that’s not inflation. In the real world, inflation results from too much money-creation relative to demand, and for making money more expensive, rate hikes lower the demand for it.

 

A lot of commentary in the aftermath of the Fed’s August 8 pause suggested that in avoiding the inevitable (rate hikes), the Fed was pushing back the day of reckoning, and insuring harsh measures to root out inflation in the future. While it’s true that $600-plus gold is inflationary and a problem, if the future were so bleak, the Dow and Nasdaq would not have rallied so handsomely after the Fed held steady.

 

Inflation is a decline in the monetary standard, so efforts to reverse a decline would by definition be something that markets would cheer. Importantly, the central banks of England in the 19th century, the U.S. in the 20th, and Switzerland in the late 1970s did not make their currencies valuable by making them more expensive and scarce. They made them valuable through the credibility of their commitment to stability.

 

In seeking to cool economic growth with rate hikes designed to lower the demand for money, the Fed isn’t credible. Conversely, if the Fed offers a true standard and does not waver from it, the dollar will strengthen alongside an impressive rise of dollars in circulation.

 

– John Tamny is a writer in Washington, D.C. He can be reached at jtamny@yahoo.com.

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