‘As a result, the market started to do much of the stabilizing for us, selling sterling when it approached DM3 and buying sterling whenever it dipped below it.”
This quote is from The View From No. 11, Nigel Lawson’s autobiographical account of his tenure under Margaret Thatcher as England’s Chancellor of the Exchequer. Lawson’s words deserve special attention given the dollar’s current weakness versus both gold and other currencies. Although England’s pound was not fixed to the German Deutschmark (DM) in 1987, the G7 countries were working on creating a fixed-exchange-rate regime. And having guessed that Lawson desired a pound/DM exchange of £3, traders did Lawson’s work for him. Up until the 1987 G7 meetings at the Louvre, the pound had been weak versus the Deutschmark, but quickly strengthened once Lawson’s desire to shadow the German currency became apparent.
Notably, Lawson had been raising England’s bank rate up until then, but the pound remained weak against the Deutschmark until his intentions became known. He was actually able to cut the rate from 10.5 percent to 9 percent in the aftermath of the Louvre meetings, though he ultimately reversed course when the 1987 stock market crash quashed any notion of a new worldwide monetary regime.
Lawson’s experience might offer a lesson for the U.S. Federal Reserve as it continues to debate what to do with the fed funds rate.
Lawson noted in his autobiography the “mild paradox” with interest rates, specifically that “In a low inflation world rates are lower than in a high inflation one.” Just as efforts to curb the demand for credit with higher rates didn’t always succeed in strengthening the pound, so have similar efforts to curb dollar demand failed in making the dollar stronger. Without a credible commitment to some kind of price rule, rate hikes can just as easily coincide with weak currency performance as they do with currency strength.
Lawson went on to say that “without financial market credibility it is hard to make a success of any monetary policy.” These words also deserve special attention given the Fed’s pre-occupation with “incoming data” about growth, resource utilization, and aggregate demand as opposed to the dollar’s value versus gold and other currencies. Credible currencies have low, rather than high, interest rates attached to them precisely because the underlying policy is credible.
In a recent speech in China, Fed chair Ben Bernanke pressed for a stronger yuan, something that will at best blunt the presumed dollar-strengthening effect of higher interest rates. A stronger yuan versus the dollar could be achieved in one of two ways, and assuming China rightfully resists following the deflationary path Japan took beginning in 1985, a stronger yuan will be achieved with a weaker, more inflationary dollar.
Whether the Fed chooses to raise or cut interest rates in 2007, it’s hard to imagine that either move will succeed in strengthening the dollar so long as the underlying policy is driven by internal economic conditions and external (yuan) currency conditions rather than a dollar-price rule. Indeed, with a fed funds target of 5.25 percent, the short rate on dollars is already higher than the rate targets for the euro, pound, yen, and Canadian dollar. That the dollar remains mostly weak against all four currencies suggests a problem of policy rather than a funds rate that is too low.
Given the Fed’s pre-occupation with economic indicators, more rate hiking would be an implicit admission that it continues to target non-monetary factors to tackle what is very much a monetary phenomenon. Conversely, while rate cuts might lead to short-term dollar strength, they too will be ineffective over the long-term so long as markets discount future rate hikes meant to slow a growing economy.
It is said that the Fed can do the right thing for the wrong reason when it comes to interest-rate targeting and, as such, that it can strengthen the dollar with rate hikes even if it is targeting growth. This assumes that currency demand is stable in the face of bad policy. The dollar’s consistently changing value correctly suggests that demand is uneven. So when the Fed raises rates to “cool” the economy with no dollar price in mind the result is often a weaker currency.
Investors invest for the long-term, and if the underlying monetary policy is not credible, there exists no fed funds rate that will shore up the dollar’s value. If high rates were somehow a cure, then Brazil, Venezuela, and Lebanon would consistently possess stronger currencies than the rest of the world.
In a 1978 Times of London article, Lawson wrote, “Rules rule: OK?” The answer to today’s dollar weakness is not more rate machinations, but a clear and credible dollar-price rule. Once in place, the markets will do the Fed’s work for it, and short rates will fall. The Fed will thankfully be superfluous.
– John Tamny is a writer in Washington, D.C. He can be reached at jtamny@yahoo.com.