The Federal Reserve decided at its recent meeting to pause hiking its target interest rate at 5.25% after raising it at 10 consecutive meetings from 0%. But don’t expect the relief to last long as the Fed will likely raise this rate in July and future meetings up to 6% by the end of the year.
The Fed’s current pause has been met with a flurry of hikes in interest rates in other countries, which could mean trouble for Americans.
The European Central Bank increased its main rate to 4%; Bank of England hiked its rate to 5%, Turkey raised its rate to 15%, and Argentina hiked its rate to a staggering 97%.
Now that higher returns are available in other countries with rising or higher interest rates than in the U.S., the value of the U.S. dollar will fall having a domino effect that would further burden struggling Americans.
The Fed will soon have to raise its target interest rate again and likely further than what could have been the case had it not paused. This is because the resulting decline in the value of the dollar will lead to more expensive imports contributing to higher inflation, economic hindrances, and the need for further tightening by the Fed.
And financial conditions remain loose as there’s much money sloshing around in the markets, which is why the Fed should be more aggressively cutting its balance sheet instead of focusing so much on its target interest rate.
Investors will be drawn to the higher returns available in these high-interest rate countries, which will increase demand for their currencies relative to the U.S. dollar thereby appreciating the foreign currency and depreciating the dollar. This will raise the cost of imports from those countries, leading to more domestic inflation or fewer purchases to satisfy one’s desires.
The last thing Americans need is for their purchasing power to be further reduced because we’ve paused our interest rate hikes while so much of the world is doing the opposite. Recent reports reveal that Americans are still struggling because of inflation, which remains hot at about 4% over the last year.
Food prices increased in May at home and away from home, and shelter and new vehicle prices are up. While wages are rising slightly, they still aren’t keeping pace with inflation year-over-year for 26 straight months.
Times are tough, which is why the Fed needs to cut the one policy tool it can control which is its balance sheet. And by a lot.
While the money supply known as M2 and the Fed’s monetary base are declining year-over-year at some of the fastest paces on record because of recent Fed actions, these declines follow the most rapid increases on record, which left their levels extraordinarily high.
These extreme increases resulted in persistent inflation and massive distortions across the marketplace.
Just as the markets were hurt by the Fed increasing its monetary base, so can the markets improve with fewer distortions by the Fed decreasing its balance sheet. By relying less on government intervention and artificial liquidity, markets can get closer to being free markets.
Specifically, the Fed should start cutting its balance sheet by at least 12% year-over-year instead of the current 6% annual rate and removing its injections in mortgage-backed securities and long-term Treasury securities. The result will be a harder economic landing but one that’s necessary given how the government failures over the last couple of years have propped up many areas of the economy with malinvestments that can’t last when cheap credit and loose financial conditions collapse.
The resulting recession will be tough, though it was avoidable without these government interventions. But if the government lets markets work, the economy would stabilize more quickly. The long-term result would be that wages keep pace or grow faster than inflation again, cooking at home would be cheaper than eating out, and debts would decrease.
Unfortunately, fiscal policy by Congress continues to run amok with massive deficits that must be partially financed by the Fed or risk soaring interest rates, massive net interest payments on the debt, unsustainable budgets, and further soaring inflation and interest rates. This isn’t a pretty scenario but it’s one that officials in D.C. put us in and we must face the difficult choices to get out of it.
When the balance sheet is cut and interest rates go up in the U.S., money will flow back into the U.S. helping to appreciate the dollar and reduce the cost of imports. There’s nothing particularly important about trade deficits or surpluses as those are equal to capital account surpluses or deficits, respectively, but the hit to the purchasing power of the dollar for Americans is highly important.
Now more than ever, the Fed needs to take drastic measures to improve our economy before it’s choked out by international currencies strengthening. Will it act before it’s too late?
Originally published at Daily Caller.
Vance Ginn, Ph.D.