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What about Inflation and the Dollar?

Bernanke’s rate cut, expected to be followed soon by additional rate cuts at the next Fed meeting, helped the stock markets and the rich investors avoid a deep drop last week, but what effect will it have on inflation in the US and the value of the dollar? It’s likely to be negative on both counts. The usual monetary tool to stop inflation is higher interest rates, which also depresses business. Unfortunately, cutting interest rates tends to encourage inflation, and it is likely to do so in this case. Furthermore, currency traders tend to invest in currencies that give a good rate of return, interest, on their holdings. Lowering interest rates discourages people from investing in that currency, the dollar. Therefore the rate cut will likely have the effect of lowering the value of the dollar. The effect may not be immediate, because the dollar is currently at almost historic lows against most major currencies, the yen, euro and pound. It may take a while for people to get used to even lower values for the dollar.

The US has a great incentive to allow inflation and devaluation of the dollar because of our huge debt. It’s a common practice for third rate developing countries to run up huge debts with foreign lenders and then devalue their currencies so that they pay off the debt with cheaper money. Thus, if the dollar eventually is worth many less Chinese yuans, the US will have to sell a lot fewer goods overseas to pay off the billions we owe China. That’s not going to happen immediately because the Chinese persist in pegging the yuan to the dollar, but if the dollar really starts to tank, they may change their mind. But it’s a complicated case, like the one where if you owe the bank $1,000 and can’t pay, you are at the bank’s mercy, but if you owe the bank $10 billion and can’t pay, the bank is at your mercy. Thus we and the Chinese each have leverage on each other.

The Economist magazine takes Bernanke to task for his precipitous cut in interest rates, mainly because it smacks of panic. But it’s also likely to have some harmful long-term effects.

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