Fed Has Lost Control Over Interest Rates

The dollar is poised on the edge -- maybe not on the very edge but increasingly close to it -- of a very nasty negative feedback loop: A falling dollar leads to dollar selling, which leads to a falling dollar, which leads to more selling. Once a rush for the exits like that starts, it's hard to stop without some of the players getting badly hurt in the melee.

The U.S. Federal Reserve knows this and is, I believe, determined to head off the possibility of that kind of dollar panic. If strong words about the need for higher interest rates -- blamed on stubborn inflation rather than a global glut of dollars -- will do the trick, all well and good.

If it takes stronger medicine -- an actual increase in U.S. interest rates -- to do the trick, I think the Federal Reserve will raise interest rates, even if the economy is weaker than it would like. The cost of letting a dollar decline turn into a run on the dollar is simply too high. To the Fed, the domestic and, indeed, global damage of a run on the dollar outweighs the purely domestic costs of a period of slow or no growth.

Better Now Than Later?

The choice is easier for the Fed than it would be for you or me. The Fed knows that, once started, the only way to end a dollar panic would be through massive increases in U.S. interest rates. Better to raise rates a little now, even if it creates unemployment and takes a bite out of stock and bond prices, than to face the need to raise rates so high later that it risks sending the U.S. economy into a recession that could be deep enough to take the rest of the global economy with it.