Greater Possibility or Has It Arrived?

Three months ago, I mentioned that the United States was being in the risk of stagflation. This worried fear is now being echoed by the Federal Reserve found in NYT's 21 Feb 2008, "That ’70s Look: Stagflation" by Graham Bowley and NYT's 21 Feb 2008, "Rising Inflation Limits the Fed as Growth Lags " by Edmund L. Andrews and Michael M. Grynbaum.

Even with the current interest rate cuts, the financial market in the United States is not improving. The current paralysis is affecting not only the macroeconomics of the United States but the entire world as well. The lowering of interest rates has made the value of USD to be even less than before. Using Pacific FX Database (http://fx.sauder.ubc.ca/), the monthly value of Gold Ounces against USD is at it's lowest point in Jan 2008 (not able to use Feb 2008 as the full month as yet to pass), since inception of the database of Nov 1991.

With the value of the USD being at its lowest, it will only cause the trade deficit of USD 711.6 billion for Year 2007 ( http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf) to be more costly if its repayment terms are in the foreign countries' currencies. Luckily for the United States, this has yet to happen as USD is the major currency of trade at the moment. Should it be another country like Thailand or Indonesia which had a huge trade deficit, the financial sectors would have collapse overnight as seen in the Asian Financial Crisis.

As imports become more expensive due to a weaker dollar, corporates and consumers should reduce consumption of foreign goods which would help to reduce the current trade deficit (in USD terms). This would be possible if the income elasticity of corporates and consumers are elastic, such that the decline in the USD value against other currencies will enable corporates and consumers to switch to local products. Should elasticity be inelastic, the weaker USD will only cause a bigger trade deficit which will further burden the US economy in the long run.

The trade deficit is still being financed by Asian countries as they have hordes of USD reserves. This financing will still continue as trade is still being done in USD. But with the falling USD value, these countries may reconsider their reserve currencies portfolio's USD weightage. The falling USD is making these reserves less in value. By re-aligning the USD weightage, the Asian countries would be able to save their reserves from FX losses. However the re-alignment has to be done in a small batches. A huge sudden re-alignment may cause the USD to fall further which may result in a melt-down of the world's financial markets.

The Federal Reserve has to make the important decision, and now! The apparent decisions to cut interest rates is not improving the economy. Either the Fed cuts interest rates up to the point where the current credit crunch is gone and confidence is restored or the Fed increases interest rates to strengthen the dollar to combat import-inflation. However, the latter does have its repercussion.

The increase in interest rates would increase the cost of borrowing for the United States. If there is not enough reserves, which the United States does not have, it will only increase its debt to the world. The United States has a budget deficit of USD 5,035.3 billion as of 2007 (http://www.cbo.gov/budget/historical.shtml).

There could be another possibility, but the US public may not be willing to accept. The Fed could personally insure all US banks and make good all borrowings between banks at this point in time to reduce the credit crunch. However, there could be a public outcry due to the usage of public funds bailing out private companies.

Even if there is no public outcry, this is also not a fool-proof plan due to moral hazard of banks coming into play. Banks, knowing that the Fed would 'sign the blank cheque', enter into risker deals which results in more problems later on. Regulatory controls could be enforced onto the banks to prevent such deals from ever taking place. Would the US financial market, deemed as a free market, ever allow regulatory controls to be implemented?

The world has become more uncertain with inapt decisions by the Fed and intertwined financial markets.