Bad things happen when the Fed overreacts to negative market psychology. The dollar’s continuing slide is a case in point.
Markets have been in a tizzy since the subprime fiasco began, even though the housing market is a tiny fraction of the overall economy. While credit markets have had violent hiccups, the economy has nonetheless kept growing smartly. GDP growth was a whopping 3.9 percent in the third quarter. Yet the Fed cut the federal-funds rate 0.75 percent. The rest of the world saw this capitulation to the market’s nervous Nellies as inflationary, and became less willing to hold dollars. If the Fed had acted correctly, responding to the state of the economy rather than to a state of mind, the dollar would be stronger today, and closer to its intrinsic value.
The Fed’s inappropriate rate cut makes U.S. assets less attractive. But prices adjust in a free economy. Now that the dollar is lower, U.S. products will become more competitive. This will drive up exports and profits as well as the demand for U.S. assets, which will staunch the bleeding.
But perhaps not enough. Since China continues to peg its currency to the dollar, a lower dollar does nothing to reduce our large trade deficit with that country. Currency traders know that a significant part of our total deficit is thus immune to changes in the dollar’s value, and wonder, as do we, how far the dollar can fall before it finds a new trading range. In this environment, downward pressure from mistaken Fed policy will inevitably induce dramatic swings in the dollar.
If the Fed is the cause of the weak dollar, then the dollar will not recover until rates go back up, which may well happen next year if the economy stays as strong as it still seems to be. If the economy weakens, however, the Fed may have to choose between recession and inflation. Small deviations from free-market principle can have outsized consequences.