Cleveland Federal Reserve Fires Warning Shot

In a stark reminder to U.S. lawmakers and capital markets, the Cleveland regional office of the Federal Reserve today warned that the depreciating dollar will have major consequences on the domestic economy over the coming months.

With the U.S. dollar having depreciated against major world currencies by around 30% since 2002, the statement from the Cleveland Fed could be seen as a further reminder to the President and his allies in Congress that the days of foreign funding of the spiraling federal budget deficits will soon come to an end. Interestingly, however, while the statement points out that the collapsing dollar will eventually cause U.S. exports to rise and foreign imports to fall, the latest numbers released earlier this week showed the U.S. trade deficit still skyrocketing, meaning that the tide will be unlikely to turn until the dollar has dropped even further.

Once that happens, however, foreigners who have been selling large quantities of imports here will no longer have the large inflow of greenbacks that they have then used to fund the federal government's record borrowing. This means, among other things, that the U.S. Treasury will find itself paying higher and higher interest rates to keep attracting lenders, and those lenders will have to show up from more varied sources, like U.S. investors, who will be willing to save more once interest rates across the economy become high enough.

One of the adverse side effects of this, however, will be that every dollar U.S. consumers put into savings—which will ultimately end up adding to the supply of lendable funds—is a dollar those U.S. consumers won't be spending on goods and services that businesses produce. And if businesses aren't selling their products to consumers, they'll lay off workers in even greater numbers than they already have been.

Another adverse side effect of all this is that, as the dollar declines and foreign imports to the U.S. become more expensive, domestic producers of competing products will also, to the extent that they can, raise their prices in lock step. This could push prices up across industry sectors, feeding inflationary expectations. If those expectations persist for long enough, interest rates on everything from car loans to home mortgages will start to impound a larger and larger "expected inflation premium." With interest rates already on their way up, such an extra kicker could send interest rates to levels that would stagnate the economy for months if not years.

While neo-conservative and certain other economists see rising U.S. savings rates as ideal, many in the business world would prefer that consumers spend their disposable income on goods and services. And while the Bush Administration has largely, if not publicly, endorsed the steady depreciation of the U.S. dollar to the end of encouraging exports and discouraging imports, many consumers would likely prefer to not to have rising prices on what they purchase, regardless of whether it has been produced overseas or domestically.

Unfortunately, the solution that would re-establish a strong dollar, and at the same time bring the record trade deficits under control, is the one thing the ruling party has, over three Administrations in fewer than three decades, never been able to do: carry out responsible fiscal policies that prevent massive, continuing, and growing federal budget deficits.