Fed Has Lost Control Over Interest Rates

Sure, there are lots of good reasons to hold dollars and dollar-denominated investments. The yields are higher on U.S. Treasuries and the notes of agencies such as Fannie Mae(FNM Quote). The markets are deeper. The euro is still a relatively untested currency, and Japan, the home of the yen, is still crawling, maybe, out of a decade-plus of deflation. And most important of all, keeping currencies like the Chinese yuan cheap in relation to the dollar keeps Chinese goods cheap, keeps Chinese exports growing, keeps factories humming and provides new jobs for a restless Chinese population.

Patience Has Limits

But that doesn't mean, if you're a central banker in Beijing, Tokyo, Moscow, Riyadh or Frankfurt, that you're willing to sit in dollars forever. Especially if it looks like the dollar will be worth less tomorrow than it is today. Already, Chinese monetary authorities have made it clear that they are putting a smaller percentage of their new foreign-exchange earnings into dollars.

That's a long way from selling dollars, and so far the Chinese are staying in dollars while looking for higher yields than Treasuries pay. But it shows that the Chinese, and the rest of the world's central bankers, are in the midst of an active review of their options.

All it would take for them to exercise one of those options and begin selling dollars would be a conviction that the drop in the dollar is no longer controlled and that the best choice in a bad situation is to sell dollars now before more damage is done to the value of those carefully acquired dollar reserves.

Toward the Precipice

The Fed knows that the U.S. dollar can rely on the economic self-interest of our biggest trading partners, but it knows that the willingness to hold even a slowly declining dollar created by that self-interest isn't endless, and that continued U.S. trade deficits have eroded that willingness.