Thursday, November 27, 2008

Real Interest Rates and the Dollar?

Nouriel Roubini has been calling for stag-deflation for some time, but worsening economic news, mounting budget deficits, and a swelling Fed balance sheet give his latest warnings even more urgency. The bad news in his latest posting at RGE Monitor includes these snippets:
At this rate of contraction as revealed by the latest data it would not be surprising if fourth quarter GDP were to fall at an annualized rate of
... the balance sheet of the Fed – already grown from $800 billion to over $2 trillion – will be expanded further as most of the new bailout actions and new programs will be financed via injections of liquidity rather than issuance of public debt.

Desperate times and desperate economic news require desperate policy actions ... The Treasury will be issuing in the next two years about $2 trillion of additional debt ...

The amounts of money involved are staggering, so is it no surprise that Roubini concludes (emphasis mine):

These policies – however partially necessary – will eventually lead to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

When and how severely will these injections of liquidity and swelling debt result in higher real interest rates and weaken the US dollar? Roubini is not alone in thinking that we are about at that point, a good example being these snippets from a recent article in the Financial Times:

The banks have been recapitalised. The government has started buying and guaranteeing distressed debt. Finally, the Federal Reserve has begun in earnest to use its balance sheet (in a sterilised manner) to step into the absent shoes of the private sector in the financial system.

A failure of the initial set of policies to reflate the economy is likely to lead to the next, more risky, set of policy choices – those involving unsterilised intervention.

As the US embarks on the next set of policy choices for curing deflation, as outlined by Ben Bernanke, Fed chairman, in his 2002 speech “Deflation – Making Sure it Doesn’t Happen here” – inflationary risks will begin to rise. With that comes the risk of sustained medium term dollar weakness and the risk ultimately of the demise of the dollar as the world’s sole reserve currency.


"Desperate Measures by Desperate Policy Makers in Desperate Times: the Fed Moves to Radically Unorthodox Policies as Economy Is in Free Fall and Stag-Deflation Deepens"
by Nouriel Roubini
RGE Monitor, Nov 26, 2008

"Insight: US debt puts strain on dollar"
by Chris Watling
Financial Times, November 26, 2008,Authorised=false.html?