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hen the Federal Reserve Open Market Committee met last week, no one expected it to raise the federal funds rate—the overnight bank rate that now hovers below 0.25 percent. However, businesses, politicians, and prognosticators are eager, perhaps inappropriately so, to hear clues about when it will begin raising short-term interest rates to a more normal level.
Simply, Fed policy is much less relevant to U.S. growth and price stability than in the days of Paul Volcker, because China’s yuan policy has substantially limited the importance of Fed interest rate decisions by severing the historic link between short interest rates—like the federal funds rate it targets—and long rates on mortgages, corporate bonds, and the securities banks use to finance lending on cars and credit cards.
Through the boom years of the last decade, Beijing printed yuan to purchase hundreds of billions of dollars in foreign exchange markets. That made the yuan and Chinese products on U.S. store shelves artificially cheap, and imports from China, coupled with higher prices for imported oil, pushed the U.S. trade deficit to more than 5 percent of GDP from 2004 to 2008.
When Americans spend that much more abroad than foreigners purchase in the United States, American goods pile up in warehouses and a steep recession will result, unless Americans spend much more than they earn or produce.
During the boom, China facilitated such folly by using its dollars to purchase U.S. Treasury securities, and that kept U.S. long interest rates artificially low, even in the face of Federal Reserve efforts to rein in spending.
From 2003 to 2006, easy terms prevailed on mortgages, homeowner lines of credit, car loans, and credit cards even as the Fed raised the federal funds rate. Americans borrowed against their homes, pushed real estate prices to unreasonable levels, and spent on Chinese goods at Wal-Mart until the credit bubble burst in late 2007 and 2008.
China continues to recklessly print yuan to buy dollars and U.S. Treasuries, and all those yuan are creating inflation and real estate speculation in China that Beijing can’t contain.
With the dollar still overvalued by some 40 or 50 percent against the yuan, the U.S. trade deficit with China, and other Asian countries practicing similar currency mercantilism, is growing again. This deficit saps demand for U.S. goods and services, slows U.S. recovery, and suppresses U.S. land values, and fuels fears of deflation in the United States, even though the U.S. banking system is flush with cheap credit from the Fed.
