The downside of interest rate cuts

The darker side of interest rate cuts

Excerpt:

Compelling as it may be, a rate-cutting policy may not always have the desired salutary effect; after all, Japan effectively had interest rates of near-zero percent for years without emerging from its economic gloom. And it carries its own costs. Lower rates boost the economy by making big purchases such as houses more affordable. They can also help banks rebuild their balance sheets, by enabling them to borrow at lower rates and lend at higher ones. But lower rates also tend to reduce the value of the dollar, which has already fallen sharply in recent years amid a surge in U.S. consumption funded by overseas borrowing. Further declines in the dollar raise the risk of boosting inflation, which hurts consumers by reducing their purchasing power.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C., says the Fed's latest round of rate cuts risks adding to pressure on the dollar. He notes that unlike the Fed, the European Central Bank has been holding its interest rate target steady. So the latest Fed rate cut puts U.S. short-term interest rates, at 3.5 percent, below the 4 percent level of the euro zone. That differential tends to make the euro, which has already appreciated sharply against the dollar in recent years, even more attractive to investors shopping for places to put their money.

Indeed, currency analysts at Merrill Lynch wrote this week that they expect the dollar to fall further if the Fed continues to cut rates. The analysts write that they see dollar negatives in the "the erosion of the [dollar] as a safe haven, the lack of private sector buying, central bank flows and a widening interest rate differential." The worries about the strength of the dollar point to the Achilles heel of the U.S. economy: the fact that U.S. consumers have been financing their consumption by borrowing cheaply overseas.


Comment: Summary: rates go down, Dollar devalues. Gold goes up (most people don't care) but so does oil (and most people do!)