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 this, 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 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.
Recent actions by the Federal
Reserve to fight inflation have aggravated the dollar’s sharp overvaluation:
- 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.
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:
- 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.
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.
December 28, 2022
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.
