Question: What can be done to increase the effectiveness of the Fed’s inflation-fighting tools and to reduce the risk of causing yet another recession?
Summary Answer: The effectiveness of the Fed’s key inflation fighting tools – higher interest rates and quantitative tightening (QT) – has suffered because raising US interest rates with the Fed Funds Rate plus quantitative tightening increase the difference or “spread” between yields in America and those in foreign markets. The increased spread annually attracts billions if not trillions of additional dollars of foreign capital flows into the United States. These inflows increase the stock of credit in America’s financial sector, offsetting some of the Fed’s quantitative tightening efforts. Also, the inflows make banks hesitant to raise their interest rates because, given the glut of capital available, finding customers willing to pay the higher interest rates is difficult.
Consequently, the Fed must raise interest rates repeatedly. Each time it does, it increases the risk of cutting off economic growth and triggering a recession.
But the story gets worse: The exceptional foreign demand for dollars and dollar-based assets driven by the rising spread between interest rates here and abroad pushes the dollar’s exchange rate so high that American goods find it increasingly hard to compete domestically against imports or as exports to foreign markets. This seriously suppresses economic activity in America, increasing the risk that constantly rising Fed Funds Rates will drive the country into a recession.
The solution is to introduce a Fed Inflation Reduction Excise (FIRE) charge that is linked to increases in the Fed Funds Rate. Such a charge would keep increases in the Fed Funds Rate from widening spreads between foreign and US financial markets, would reinforce Fed efforts to tighten and raise the cost of credit in US markets, and would limit the collateral damage to the real economy caused by excessive dollar appreciation.
Background: The US dollar first rose above its trade balancing level during the OPEC Oil Crises of the 1970s and early 1980s. To varying degrees, the dollar has remained overvalued ever since. As a share of GDP, our trade deficits in some years have exceeded those in some of the world’s most mismanaged developing countries like Sudan, and these deficits have accumulated so fast that America’s foreign debt (as measured by our net international investment position or NIIP) is eighteen times larger than that of Great Britain, the second largest foreign debtor in the world.[1]
Over the past 50 years, America’s trade deficits have accounted for up to 75 percent of all trade deficits in the world. Servicing the stock of debt accumulated because of these annual deficits already puts a heavy burden on Americans, and at the rate our foreign debt -- and our govenrment debt -- continue to grow, the burden on future generations could become unbearable. Our children and grandchildren could end up with a standard of living worse rather than better than our own.
The US dollar’s overvaluation relative to an exchange rate that would allow Americans to earn as much producing exports as they spend on imports was estimated by Ferry of CPA at nearly 17 percent based on data ending in 2021. Between January and September of 2022, the dollar appreciated by another 10 percent, bringing total dollar overvaluation to somewhere between 25 and 30 percent.[2]
The dollar has become seriously overvalued because the global demand for dollars and dollar-based assets such as stocks, bonds, and real estate exceeds the supply for many reasons. For example:
the dollar is by far the most widely used currency for international trade and for holding international reserves;America’s dollar-based financial markets are among the deepest, broadest, and safest in the world;dollars and dollar-based assets are regarded as a “safe-haven” where foreign investors like to hold their money during the world's frequent crises. While the Fed has been raising interest rates rapidly to fight inflation, other central banks have been keeping their interest rates low or even negative to stimulate economic growth. Consequently, the spreads between returns in America and those abroad have widened to levels that generate trillions of dollars per year of inbound carry trade by speculators seeking to exploit America’s higher interest rates.Investors and speculators assume that the Fed and Treasury will continue to allow the dollar to appreciate. Unfortunately, this assumption is rational given America’s long-standing belief in a so-called “strong dollar" -- a belief that continues despite the common anger of Americans about the "undervaluation" of foreign currencies like the Chinese renminbi and the Japanese yen. (The dollar's overvaluation is simply the inverse of the collective undervaluation of the currencies of its trading partners.)Anticipation of continued dollar appreciation reinforces incentives such as the widening yield gap for foreign speculators to bring even more foreign capital into the US. Unless the urgently needed countermeasures proposed below are implemented, the dollar will continue to appreciate, making made-in-America goods even less competitive than they are today, and this will definitely increase the risk of a recession.[3]Today’s massive inflows of foreign capital are destroying the effectiveness of Fed measures designed to raise interest rates. For example, raising the FFR will not raise other domestic interest rates such as the prime rate by as much as they normally would because banks are hesitant to raise rates when they are having trouble “selling” the excessive volumes of credit already on hand because of such large foreign capital inflows – a major problem during the housing bubble of the mid-aughties for example.By increasing the availability of credit in the banking system, the foreign inflows are partially or largely offsetting the Fed’s quantitative tightening efforts. Despite the ruinous impact of excessive inflows of speculative foreign capital on Americas’ international competitiveness, economic growth, jobs, budget deficits, and the national debt, the Fed and the Treasury have made no effort to moderate inflows of foreign capital or to keep them at levels consistent with a value for the US dollar that would balance America’s international trade, or to keep them consistent with a supply of credit in America that would be consistent with stable prices. Because of the negative impacts of excessive inflows of foreign capital triggered by rising spreads between foreign and US financial markets, the Fed must keep raising interest rates and keep selling the bonds it holds on its balance sheet to pull money out of the economy. This makes the situation even worse on all fronts.For example, the more the Fed raises interest rates and tightens credit availability, the greater will be the risk of a recession. As we saw during the Great Financial Crisis of 2007-2009, for example, such recessions can cause far more harm to Americans -- from the very rich to the very poor -- than a percent or two of additional inflation would have caused.Most recessions in the past fifty years have been triggered by increases in the FFR totaling only 200-400 basis points from the previous trough. The Fed has already raised the upper limit of the Fed Funds Rate this year from 0.25 percent in March to 4.5 percent in December– a 425 basis point increase in barely six months. Thus we are already into the range where FFR increases are very likely to cause another recession.Proposed Policy Action
Recent actions by the Federal Reserve to fight inflation have aggravated the dollar’s sharp overvaluation:
Lessons Learned: The Fed clearly needs to raise interest rates to control inflation, but it also needs to moderate the inflows of foreign capital that make its efforts to control inflation less effective and that increase the risk of causing another recession. Otherwise, the Fed will continue to cause the inflation it seeks to reduce.
Widening cross-border spreads between foreign and US interest rates plus anticipated appreciation of the dollar are the primary factors stimulating excessive inflows of foreign-source money. Therefore the solution lies in breaking the link between rising interest rates in US markets (which are driven by increases in the Fed Funds Rates), and the interest rates that foreign investors can earn in America’s financial markets.
In short, the Fed needs to break the link between increases in the Fed Funds Rate and increases in cross-border interest rate spreads.
If the Fed can break this link, it will simultaneously put an end to foreign speculators' anticipation of further dollar appreciation, which is the other factor that drives excessive inflows of foreign money. The end result would be a much-reduced risks of a recession in the short term, and much-enhanced prospects for excellent competitiveness, output growth, job creation, reduced government deficits, and reduced public debt in the longer term.
The Need for Immediate Action
The urgency of reducing excess foreign capital inflows could not be clearer:
Corrective action is urgently needed. The Fed should introduce a Fed Inflation Reduction Excise (FIRE) charge that would act like an import tax on the unwanted foreign capital inflows that damage and distort the American economy. The charge would initially be set at a rate equal to today’s interest rate spread between the Fed Funds Rate and the average policy rate of the central banks of countries contributing most to the current flows of capital into the United States (e.g. Great Britain, the Eurozone, and Japan). This would eliminate the cross-border interest rate spread that currently draws trillions of dollars of largely speculative capital into America from abroad each year.[4]
Administration: When the FOMC decides that domestic inflation is getting out of hand and needs to be controlled, the Fed staff would do the same analysis that they currently do to support decisions of the Federal Open Market Committee (FOMC), and the FOMC would continue to use its traditional interest rate and QT tools in the traditional manner.
However, once the FOMC has decided to increase the lower and upper bounds of the Fed Funds Rate, it would simultaneously announce that the FIRE rate has been raised by the amount of the increase in the Fed Funds Rate. This simple announcement, with no additional analytical work by Fed staff, would prevent creating or increasing a cross-country spread that would otherwise attract more foreign money into America’s already sated capital markets. And by doing so, the FIRE would greatly reduce upward pressures on the dollar’s exchange rate, thereby increasing the competitiveness of American industry and all the benefits that will flow therefrom.
Collection: How would the FIRE be collected, you may ask. Very simple. Virtually all foreign capital flowing into the United States comes via an international payments system such as SWIFT and is received by a correspondent bank located in the United States. Such banks, which must already file certain reports to the US Treasury, would simply deduct the amount of the FIRE from the incoming payment order, send it electronically to the US Treasury as part of the transaction process, and deposit the remainder of the funds received in a US bank account of the designated recipient.[5]
Summary: By eliminating today’s incentives to dump unwanted, damaging foreign capital into America’s financial markets, FCL would make the Federal Reserve’s Fed Funds Rate (FFR) and Quantitative Tightening (QT) far more effective and would reduce or eliminate the overvaluation of the dollar that (a) destroys US growth, jobs, and factories, (b) increases government deficits, public debt, trade deficits, and debt to foreigners, and (c) increases the risk that controlling inflation will both cause a recession and make it harder for America to recover from a recession.
Greater effectiveness of the FFR and QT would reduce the need to keep raising the Fed Funds Rate or to sell even more of the Fed’s balance sheet assets to soak up more of the excess money in America's financial markets. By helping move the dollar to a more fully competitive, trade-balancing rate, the FIRE would gradually allow made-in-America goods to become fully competitive domestically against imports and as exports to foreign markets, thereby helping to eliminate US trade deficits and triggering new investments that increase US productivity,
In short, the Fed Inflation Reduction Excise charge, which would require no additional analysis by Fed staff, would significantly increase the Fed’s ability to fulfill its Dual Mandate from Congress – keeping prices stable by fighting inflation, and assuring maximum feasible domestic employment. At the same time, FIRE would greatly reduce the risk of recessions or worse, allow America to recover more quickly in the event of a recession, and help it attain the American Dream of steady, sustainable growth with benefits shared by all.
And as a side benefit, the billions of dollars that would be collected with the FIRE charge could be used to reduce or eliminate US budget deficits, reduce inflation-generating borrowing to finance these deficits, reduce our national debt, and help finance important investments in the future of our country – all with no increase in taxes on Americans.
In short, with this proposal in place, the Fed could Fight Inflation and Recessions Efficiently with the Fed Inflation Reduction Excise -- otherwise known as fighting fire with fire to save America.
Note: The Fed Inflation Reduction Excise (FIRE) system was designed on the basis of solid statistical data that help explain why the Fed’s current tools for fighting inflation involve a serious risk of causing recessions. These data will soon be available in chart form with interpretive commentary.
America Needs a Competitive Dollar - Now!
[1] It is no coincidence that America and Britain also have the largest financial sectors in the world. Both have developed a “comparative advantage” in financial trade that seriously disadvantages their real sectors – those that produce exports. This is a special form of the infamous “Dutch Disease” that developed when the Netherlands began exporting so much oil that its traditional industries could no longer compete internationally.
[2] Note that the estimates here of the dollar’s overvaluation reflect average “trade-weighted” movements in the exchange rates of the dollar against the currencies of America’s major trading partners. Under- and over-valuation by individual trading partners can vary widely from these averages.
[3] The focus of foreign speculators on cross-border spreads and on expectations of further dollar appreciation are explained in more detail by literature on “uncovered interest rate parity.” (See, for example, Mishkin, 2006)
[4] Some may worry that discouraging inflows of foreign capital will reduce the availability and increase the cost of the capital needed to increase the productivity of American manufacturing. However, most carry trade flows are strictly financial, largely speculative, and usually short-term. Such money is generally not used to enhance America’s physical production capacity or to increase its real productivity. Furthermore, once the dollar has moved to levels that restore the international competitiveness of the US dollar, America will be able to mobilize more than enough capital domestically to finance a major expansion in America’s productive capacity by shifting funds from speculative activities to real investments in real projects. Also, as the Foreign Capital Levy is very small compared to the profits that that they will make because making goods in America is once again profitable, foreign direct investment in America will surge.
[5] The Fed’s right to establish the FIRE needs to be confirmed. Consistent with international best practice, the Fed is an independent central bank, but it is ultimately accountable to the public and to Congress. For reasons noted in this paper, the FIRE is essential to the Fed’s ability to carry out its dual mandate from Congress and thus the FIRE should be within the Fed’s power to implement. However, should any question arise, the President, under powers granted by the International Economic Emergency Powers Act (IEEPA) could issue an executive order allowing the Federal Reserve to establish the FIRE system, and instructing the US Treasury to collect the levies as part of its ordinary business.
America Needs a Competitive Dollar - Now!
Recent actions by the Federal Reserve to fight inflation have aggravated the dollar’s sharp overvaluation:
Lessons Learned: The Fed clearly needs to raise interest rates to control inflation, but it also needs to moderate the inflows of foreign capital that make its efforts to control inflation less effective and that increase the risk of causing another recession. Otherwise, the Fed will continue to cause the inflation it seeks to reduce.
Widening cross-border spreads between foreign and US interest rates plus anticipated appreciation of the dollar are the primary factors stimulating excessive inflows of foreign-source money. Therefore the solution lies in breaking the link between rising interest rates in US markets (which are driven by increases in the Fed Funds Rates), and the interest rates that foreign investors can earn in America’s financial markets.
In short, the Fed needs to break the link between increases in the Fed Funds Rate and increases in cross-border interest rate spreads.
If the Fed can break this link, it will simultaneously put an end to foreign speculators' anticipation of further dollar appreciation, which is the other factor that drives excessive inflows of foreign money. The end result would be a much-reduced risks of a recession in the short term, and much-enhanced prospects for excellent competitiveness, output growth, job creation, reduced government deficits, and reduced public debt in the longer term.
The Need for Immediate Action
The urgency of reducing excess foreign capital inflows could not be clearer:
Corrective action is urgently needed. The Fed should introduce a Fed Inflation Reduction Excise (FIRE) charge that would act like an import tax on the unwanted foreign capital inflows that damage and distort the American economy. The charge would initially be set at a rate equal to today’s interest rate spread between the Fed Funds Rate and the average policy rate of the central banks of countries contributing most to the current flows of capital into the United States (e.g. Great Britain, the Eurozone, and Japan). This would eliminate the cross-border interest rate spread that currently draws trillions of dollars of largely speculative capital into America from abroad each year.[4]
Administration: When the FOMC decides that domestic inflation is getting out of hand and needs to be controlled, the Fed staff would do the same analysis that they currently do to support decisions of the Federal Open Market Committee (FOMC), and the FOMC would continue to use its traditional interest rate and QT tools in the traditional manner.
However, once the FOMC has decided to increase the lower and upper bounds of the Fed Funds Rate, it would simultaneously announce that the FIRE rate has been raised by the amount of the increase in the Fed Funds Rate. This simple announcement, with no additional analytical work by Fed staff, would prevent creating or increasing a cross-country spread that would otherwise attract more foreign money into America’s already sated capital markets. And by doing so, the FIRE would greatly reduce upward pressures on the dollar’s exchange rate, thereby increasing the competitiveness of American industry and all the benefits that will flow therefrom.
Collection: How would the FIRE be collected, you may ask. Very simple. Virtually all foreign capital flowing into the United States comes via an international payments system such as SWIFT and is received by a correspondent bank located in the United States. Such banks, which must already file certain reports to the US Treasury, would simply deduct the amount of the FIRE from the incoming payment order, send it electronically to the US Treasury as part of the transaction process, and deposit the remainder of the funds received in a US bank account of the designated recipient.[5]
Summary: By eliminating today’s incentives to dump unwanted, damaging foreign capital into America’s financial markets, FCL would make the Federal Reserve’s Fed Funds Rate (FFR) and Quantitative Tightening (QT) far more effective and would reduce or eliminate the overvaluation of the dollar that (a) destroys US growth, jobs, and factories, (b) increases government deficits, public debt, trade deficits, and debt to foreigners, and (c) increases the risk that controlling inflation will both cause a recession and make it harder for America to recover from a recession.
Greater effectiveness of the FFR and QT would reduce the need to keep raising the Fed Funds Rate or to sell even more of the Fed’s balance sheet assets to soak up more of the excess money in America's financial markets. By helping move the dollar to a more fully competitive, trade-balancing rate, the FIRE would gradually allow made-in-America goods to become fully competitive domestically against imports and as exports to foreign markets, thereby helping to eliminate US trade deficits and triggering new investments that increase US productivity,
In short, the Fed Inflation Reduction Excise charge, which would require no additional analysis by Fed staff, would significantly increase the Fed’s ability to fulfill its Dual Mandate from Congress – keeping prices stable by fighting inflation, and assuring maximum feasible domestic employment. At the same time, FIRE would greatly reduce the risk of recessions or worse, allow America to recover more quickly in the event of a recession, and help it attain the American Dream of steady, sustainable growth with benefits shared by all.
And as a side benefit, the billions of dollars that would be collected with the FIRE charge could be used to reduce or eliminate US budget deficits, reduce inflation-generating borrowing to finance these deficits, reduce our national debt, and help finance important investments in the future of our country – all with no increase in taxes on Americans.
In short, with this proposal in place, the Fed could Fight Inflation and Recessions Efficiently with the Fed Inflation Reduction Excise -- otherwise known as fighting fire with fire to save America.
Note: The Fed Inflation Reduction Excise (FIRE) system was designed on the basis of solid statistical data that help explain why the Fed’s current tools for fighting inflation involve a serious risk of causing recessions. These data will soon be available in chart form with interpretive commentary.
America Needs a Competitive Dollar - Now!
[1] It is no coincidence that America and Britain also have the largest financial sectors in the world. Both have developed a “comparative advantage” in financial trade that seriously disadvantages their real sectors – those that produce exports. This is a special form of the infamous “Dutch Disease” that developed when the Netherlands began exporting so much oil that its traditional industries could no longer compete internationally.
[2] Note that the estimates here of the dollar’s overvaluation reflect average “trade-weighted” movements in the exchange rates of the dollar against the currencies of America’s major trading partners. Under- and over-valuation by individual trading partners can vary widely from these averages.
[3] The focus of foreign speculators on cross-border spreads and on expectations of further dollar appreciation are explained in more detail by literature on “uncovered interest rate parity.” (See, for example, Mishkin, 2006)
[4] Some may worry that discouraging inflows of foreign capital will reduce the availability and increase the cost of the capital needed to increase the productivity of American manufacturing. However, most carry trade flows are strictly financial, largely speculative, and usually short-term. Such money is generally not used to enhance America’s physical production capacity or to increase its real productivity. Furthermore, once the dollar has moved to levels that restore the international competitiveness of the US dollar, America will be able to mobilize more than enough capital domestically to finance a major expansion in America’s productive capacity by shifting funds from speculative activities to real investments in real projects. Also, as the Foreign Capital Levy is very small compared to the profits that that they will make because making goods in America is once again profitable, foreign direct investment in America will surge.
[5] The Fed’s right to establish the FIRE needs to be confirmed. Consistent with international best practice, the Fed is an independent central bank, but it is ultimately accountable to the public and to Congress. For reasons noted in this paper, the FIRE is essential to the Fed’s ability to carry out its dual mandate from Congress and thus the FIRE should be within the Fed’s power to implement. However, should any question arise, the President, under powers granted by the International Economic Emergency Powers Act (IEEPA) could issue an executive order allowing the Federal Reserve to establish the FIRE system, and instructing the US Treasury to collect the levies as part of its ordinary business.
America Needs a Competitive Dollar - Now!
