Unintended Consequences of the US Rate Cut

I've learned that you can never tell what an unintended consequence of an action will be. Wall Street is partying now but there are plenty of ways this rate cut could go bad. Here's one.

I just read an interesting article from a writer who covers the Chinese economy for the Asian Times. The article, US rate cuts: Like a blow to the head. The article makes the case that by dropping rates so precipitously, the Fed has put the US on a collision course with China.

It’s all about currency exchange rates according to the article. China has been helping finance the massive orgy in consumer spending by parking trillions in treasury bonds, helping to hold down interest rates. As the US drops interest rates, it also devalues its currency and all US denominated assets. The Canadian dollar hit a 30 year high today is nearly at parity with the US dollar. The Chinese Yuan has been dropping for the last year and this will only further the slide.

Of course, I thought that a stronger Yuan was what the US administration wanted. There have been many arguments, the most recent in the Economist, that the Yuan is undervalued. Many believe that the dollar must fall further against the Chinese currency before they are in synch.

I wonder though what that means for the approximately $400 billion in treasuries that China holds. After all, these treasuries lose value as the dollar falls against the Yuan. In a worse case scenario, the Chinese would become fed up with the falling US dollar and political pressure to increase the value of the Yuan and begin to sell treasuries. If done quickly, interest rates would spike higher regardless of what Bernanke and the Fed want to do. Of course, China won’t do this because it will reduce the value of the Treasuries it still holds while it is selling.

A more likely scenario is the gradual sell-off of treasuries as China seeks to reduce its exposure to the dollar. Over time, this will also increase interest rates.

It’s hard to know what will happen. But what is clear is that there isn’t a free lunch and while Wall Street is partying now, we may all have to pay later.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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  • Herman Kline

    September 20, 2007

    Agreed. However, there is a built in protection mechanism here which is that rising interest rates would act as a brake against the falling dollar.

  • Richard Robbins

    September 21, 2007

    The Chinese should be madder than hell at US hypocracy and they are going to make us pay.

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