Will the Fed Raise Rates? Will the US Dollar Lose Reserve Status?
Written on 25 August 2022
by Ruth Fisher, PhD
The purpose of this analysis is to better understand the inter-relationships between prices, interest rates, and inflation and to use this understanding to answer two specific questions:
- Will the Fed increase interest rates to stem the current bout of inflation?
- Will the US Dollar lose its status as International Reserve Currency?
- Price Level
- Inflation = Increase in Price Level
- Interest Rates
- Will the Fed Increase Interest Rates?
- US Reserve Currency
To provide some context, in January 2015, the average price of a gallon of gasoline in the US was $2.21. Over the next five years, the price of gas wandered between $2 and $3, averaging $2.51 over the 2015 – 2020 period (Figure 1).
In January 2021, at the time Biden entered the White House, the average price of a gallon of gasoline in the US was $2.42, just at the average of where it had been for the past five years. However, by February 2022, the month Putin invaded Ukraine, the average price of gas in the US had reached $3.61, an increase of 49% from the January 2021 price. In July 2022, the average price of gas was $4.67, almost double its January 2021 price.
The price level, generally denoted P, is the average of current prices across the entire spectrum of goods and services produced in an economy. “In economics, price levels are a key indicator and are closely watched by economists. They play an important role in the purchasing power of consumers as well as the sale of goods and services.”
(1) Quantity Theory of Money: M x V = P x Q, where
M: Supply of money
V: Velocity of money (the rate at which people spend money, usually assumed constant)
P: General price level
Q: Quantity of goods and services produced
3 points of note:
- P is proportional to M: “According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy.”
- Decrease in Q: Supply chain disruptions during the Covid lockdowns have caused shortages in the supply of many goods, that is, Q has decreased. If the money supply, M, had remained unchanged, then the result would have been higher prices, P.
- Increase in M: However, during the Covid lockdowns, government also passed extremely large stimulus packages, that is, it vastly increased the supply of money, M. The increases in M combined with decreases in Q caused the price level, P, to skyrocket.
From a very general top-down approach, we see that the price level has increased due to a combination of increases in the supply of money and decreases in output.
The expected duration of the recent increases in prices, particularly gas and food, has been a hotbed issue. Since early 2021, as prices began rising, many in the Biden Administration expected these price increases to be a temporary result of policies and market conditions associated with Covid. For example, in May 2021, Treasury Secretary Janet Yellen said she expected inflation to be temporary. It wasn’t until the following year – in May 2022 – after prices had continued to rise, that she finally conceded she had been wrong in her expectations.
I believe the inflation we’re seeing is actually due to structural issues in the economy, which aren’t going to be fixed anytime soon (see next section).
“Inflation is a rise in prices, which can be translated as the decline of purchasing power over time.”
A decline in purchasing power occurs when inflation affects products that constitute a significant portion of people’s spending. The big categories of spending people for most people are: food, housing, and transportation. Housing costs (rent and mortgages) are closely tied to interest rates. Food prices are closely tied to transportation prices, which are closely tied to energy prices. So, increases in the price of energy increase both transportation and food prices. A quick and dirty examination thus suggests purchasing power declines when interest rates and/or the price of energy rise.
More generally, from Equation (1), P increases when the supply of money relative to national output, (M/Q), increases, that is either M rises and/or Q falls. So then this begs the questions: what causes M to rise and/or Q to fall?
i. What Decreases National Output, Q?
Output decreases with increases in either regulations or prices of factors of production (Labor, Capital, Materials (energy)).
- Regulations: The burden of regulations have been amassing over time to the point that businesses in general – and small businesses in particular – have a difficult, if not impossible time surviving.
- Labor: The Labor Force Participation Rate (LFPR) has been steadily declining over past decades for both men and women age 16 – 55 (Figure 2). LFPRs have been declining due to: increasing accessibility of welfare programs (welfare, unemployment, and disability); increasing stigmas against blue collar and fast-food work (which comprises most teen work); and more recently all the Covid stimulus payments and rent moratoriums.
- Raw Materials (Energy): The crusade against fossil fuels has radically decreased investments in and supplies of cheap fossil fuels, while only partially replacing them with much more expensive and much less reliable clean energy.
- Supply Chain Disruptions: During the Covid lockdowns, business shutdowns created massive disruptions in global supply chains. Over the past decades, competition has led companies to minimize costs of production, for example, by using globally distributed producers and just-in-time inventories. Yet, increasingly lean and mean supply chains are increasingly fragile when faced with any shocks to the system. Disruptions in supply chains during Covid are leading many companies to restructure their supply chains to make them less fragile to future shocks. This will be an ongoing process that will take place over years to come.
ii. What Increases the Supply of Money, M?
M increases when government engages in expansionary policies, including Quantitative Easing and other Low Interest Rate Policies (since the Financial Crisis) and ever larger government spending and stimulus programs (e.g., Covid, Inflation Reduction) (see Figure 3).
Consider the price of gas from Figure 1 (reproduced here for convenience). Before Jan 2021, there had been relatively little inflation in gas prices. Inflation started in Jan 2021, when the average price of gas was $2.42, and by Jul 2022, the price reached $4.67. The average monthly rate of inflation in the price of gas between Jan 2021 and Jul 2022 was 3.7%. Suppose that after July 2021, inflation ends, that is, the rate of inflation drops to 0%.
With no inflation, the price of gas in Aug 2022 will be $4.67. In other words, even though inflation has disappeared in the hypothetical, it does not mean the price of gas will necessarily drop back down to the price it had been before inflation started.
If, after inflation disappears, the July 2022 economic environment becomes the “new normal,” then the price of gas will remain at its post-inflation price of $4.67. For the price of gas to revert back to its pre-inflationary level of $2.42, the economic environment in Aug 2022 and beyond must revert back to the environment that prevailed before inflation began. Reversion to pre-inflationary prices is more likely when:
- The bout of inflation is short in duration, that is, it lasts only a few months.
- The shock to the environment causing the bout of inflation is transitory, that is, a return to the old environment is still feasible.
The longer a bout of inflation lasts and/or the less transitory it is, the greater will be both producer and consumer adaptions to the new environment, making a return to the old environment less feasible. In particular,
- Consumers often find they prefer (certain aspects of) their new lifestyles to the old (e.g., work from home rather than commute to the office), and
- Prices tend to be sticky downward, that is, suppliers tend to be slow to increase prices (especially wages) in response to increases in costs, but then slow to reduce prices back down if/when costs drop back down to their original levels.
When inflation hits, people often speak about the affordability of day-to-day costs. Affordabilityis the extent to which people have the income to buy the things they need (e.g., food, housing, and transportation). In the face of rising prices, affordability drops when people’s wages do not keep pace with increases in prices. Generally speaking, since employers generally wait to establish that inflation has staying power before they’re willing to increase wages (in part because wages tend to be sticky downward), wage increases tend to lag prices. The faster and higher prices increase, the harder it is for wages to keep pace, and the less affordable day-to-day expenses become.
To summarize, Section 1 provided an abstract overview of the economy and concluded that the price level (i.e., inflation) has increased due to a combination of increases in the supply of money and decreases in output. Section 2 provided some detail to establish more tangibly the specific reasons for inflation. Section 2 also established structural causes for the current bout of inflation, suggesting not only that prices will likely remain high, but also that inflation will likely continue into the future.
The interest rates present in markets (mortgage and financing rates, credit card rates, rates paid on deposits) are all nominal interest rates. Real rates, r, are calculated as the nominal market rates, i, less inflation, π: r = i — π.
The Federal Funds Rate is the rate banks charge each other for inter-bank loans. This is the rate set by the Federal Reserve Bank (“The Fed”), which serves as the basis for the rates banks charge borrowers. The Federal Funds rate has been at historically low levels since the Financial Crisis (see Figure 4).
Low interest rates encourage borrowing at the expense of saving and favor borrowers (debtors) at the expense of lenders (creditors). Low interest rates enable government to spend and borrow more, because there is a lower burden of interest payments. Finally, by lowering the costs of borrowing, low interest rates also promote market activity and thus increase stock market prices.
The real rate of interest, r, is equal to the nominal rate, i, less the rate of inflation, π:
(2) r(g) ≡ i(rF, risk, π) - π(M/Q, Regs, P(K, L, resources), D/S)
i. Determinants of Real Interest Rates: r = rF + risk
Real rates of interest increase with the growth rate of the economy, g. Practically speaking, real rates of interest are context-specific: they apply to particular individuals or organizations seeking credit. The real interest rate facing an entity is the sum of:
- The risk-free real rate of interest, rF, generally taken as the rate on US Treasury Bonds, considered to be a relatively risk-free investment, and
- The entity’s associated risk of default.
ii. Determinants of Nominal Interest Rates: i = rF + risk + π
Nominal interest rates are also context-specific: they apply to particular individuals or organizations seeking credit. The nominal interest rate facing an entity is the sum of:
- The risk-free real rate of interest, rF,
- The entity’s associated risk of default, and
- The rate of inflation, π.
iii. Determinants of Inflation Rates: π = π(M/Q, Regs, P(K, L, resources), D/S)
Inflation rates can be product-specific (e.g., currently the US is experiencing inflation in gas prices). However, when inflation hits products that are central to economies – food, housing, and transportation – they tend to flow through to affect entire economies. Generally speaking, inflation rates will be higher when:
- M/Q Increases: From Equation (1), inflation rates will be higher when the supply of money relative to total output, M/Q, is higher. As described in the first part of this discussion, increases in stimulus spending during Covid combined with supply chain disruptions (drops in Q), plus other longer term structural problems, have both caused M/Q to increase, thereby causing inflation.
- Regs Increase: Inflation rates will be higher when there are more regulations, which tend to drive up costs of doing business.
- P Increases: From Equation (1), inflation rates will be higher when the price level, P, is higher. Again, as described earlier, the price level increases with rises in regulations and the prices of factors of production. Shortages particularly in labor and in energy have caused prices throughout the economy to increase.
- D/S Increases: Demand increases relative to supply. Generally speaking, the Covid lockdowns shifted people’s demand away from services and toward products, while the re-opening of the economy shifted people’s demand away from products and toward services. Supply chain disruptions, combined with labor market disruptions, have caused delays in the availability of product and services. Supply has thus been having trouble keeping up with shifts in demand, leading to shortages and thus inflation.
Section 3 provided an overview of the underlying factors that affect real and nominal interest rates and the rate of inflation. Section 2 briefly touched on the issue of affordability. When talking about interest rates, what really matters is this issue of affordability, that is, the extent to which wages are keeping pace with rises in prices. In other words, what matters is real rates of interest, not so much nominal rates.
Time is needed for economic actors to adjust to changes in the economy. As a result, increases in wage rates and nominal interest rates both lag increases in inflation. Real rates of interest thus drop with inflation, thereby fueling further economic activity, thus increasing inflation. Once inflation starts, it can induce a vicious cycle of increasing inflation and activity, combined with decreasing affordability, all of which can quickly spiral out of control.
The only way to halt the feedback loops is for the Fed to intervene and increase nominal interest rates. By raising nominal rates to levels greater than inflation, the Fed will cause real rates to rise, which, in turn, will decrease economic activity, thereby dampening rising prices, i.e., inflation. So, Fed intervention can halt the vicious cycle of inflation, but at the cost of inducing economic recession.
Currently the US debt is at historically high levels (see Figure 5). There are three ways for government to get rid of debt:
- Generate budget surpluses and pay down the debt
- Default on the debt
- Inflate the debt away by inducing inflation
The first two methods are not going to happen. That leaves the third option, inflating the debt away, that is, inducing inflation. In this case, the government essentially pays off old debt using money that is worth less than that in which the original debt was incurred. The snag here is that as inflation rises, so too do interest rates, which increases the burden of servicing the debt. From the government's perspective, then, inflation can be a double-edge sword.
A blogger at the St. Louis Fed notes, “If the increase in nominal yields exceeds the increase in inflation, then the ex post real rate of interest—nominal yields adjusted for realized inflation—will go up and borrowers will have to repay more to lenders in terms of purchasing power.”
What he fails to mention, though, is the converse: that the trick, then, for government to inflate away the debt is to prevent nominal rates from increasing faster than inflation, that is, to not raise interest rates (much or enough) in response to the current bout of inflation. Hmmm. Do you think this will affect the decision the Fed is currently faced with regarding how much to raise interest rates??
The information in points i, iii, v, and viii below is taken from John Cochrane (2022, Apr 27), “Why Hasn’t the Fed Done More to Fight Inflation?”
i. The government insists that the current bout of inflation is due to a one-time shock to the system: supply chain disruptions that occurred during the Covid lockdowns. Once the supply chain problems have been resolved, so the reasoning goes, inflation will disappear.
ii. Even if inflation goes to zero, as described earlier, prices will not necessarily decrease to their pre-Covid levels.
iii. Even if the current bout of inflation is due to a one-time shock to the system, inflation may persist, since sticky prices cause lags in adjustments. “That price stickiness draws out the inflationary response to a fiscal shock is perhaps not surprising. Many stories feature such stickiness, and suggest substantial inflationary momentum. Price hikes take time to work through to wages, which then lead to additional price hikes. Housing prices take time to feed in to rents. Input price rises take time to lead to output price rises.”
iv. Then, of course, there’s the issue that the current bout of inflation isn’t just due to the Covid lockdowns, but rather, to the continued (i) war on fossil fuels, (ii) out-of-control government spending, and (iii) government’s low interest rate policies.
v. Taylor Rule: To tame inflation the Fed must raise interest rates as per the Taylor Rule: the interest rate should be 2 percent (the Fed’s inflation target), plus 1.5 times how much inflation exceeds 2 percent, plus the long-term real rate:
Taylor Rule: i = 2% + 1.5 x (inflation - 2%) + LT real rate
~ 12% (July inflation ~ 8.5%)
vi. Consequences of Increasing the Interest Rate
Increasing the interest rate will dampen economic activity, pushing the economy into recession.
Since the debt is so large (about 125% of GDB – see Figure 5), then increases in interest rates will significantly increase the burden of the debt, that is, the amount of interest payments needed to service the debt. Increases in interest payments crowd out government spending for other purposes.
vii. Consequences of Not Increasing the Interest Rate: If the government does not raise interest rates to tame inflation, inflation may continue to increase, potentially spiraling out of control.
High rates of inflation cause widespread affordability problems, which creates social unrest.
At the same time, high rates of inflation will threaten the current Reserve Status of the US dollar, that is, global demand for US dollars. Decreases in global demand for US dollars would further increase US interest rates.
viii. Adaptive Expectations vs. Rational Expectations (New Keynesian View)
“Adaptive expectations captures traditional views of monetary policy, and rational expectations captures the New Keynesian view. Their crucial difference lies in the famous Phillips curve, the relation between inflation and unemployment or output. In both models, higher output and lower unemployment come with higher inflation. In the traditional view, higher output comes with more inflation relative to past inflation. In the New Keynesian, rational-expectations view, higher output comes with more inflation relative to expected future inflation…
The New Keynesian model … fits the Fed’s inflation and unemployment forecasts well... The Fed is New Keynesian—or, at least, the Fed acts as if it is New Keynesian.
…the New Keynesian model says that in order to hit the Fed’s inflation forecast, interest rates can stay low, and indeed a bit lower than the Fed projects. And that path is perfectly consistent with unemployment slowly reverting to the natural rate.”
My view is that government wants an excuse to not raise interest rates as much as eliminating inflation would require so it can inflate away the debt without increasing the burden of servicing the debt. The Rational Expectations model provides a basis (i.e., excuse) for the government to claim that interest rates don’t need to be increased much because inflation will dissipate on its own.
There is much talk about whether the US dollar will lose its status as an International Reserve Currency as select foreign nations increasingly diversify away from the dollar toward alternative currencies (notably the yuan and the ruble).
A requisite property of reserve currencies is stability, that is, relatively low rates of inflation. As such, the greater is the magnitude and/or duration of the current bout of US inflation, the more damage it will do to already all-to-willing foreign nations to switch to alternative currencies.
“Reserve currencies thus grease the wheels of international commerce by helping countries and businesses conduct transactions using the same currency, a much simpler task than settling transactions involving different currencies… Reserve currencies are typically issued by developed, stable countries… it helps to be a developed country with a big economy with relatively free capital flows, to have a banking system able to handle being a creditor, and to have export clout.”
“The dollar’s rise to global hegemony started early in the 20th century and formalized at Bretton Woods, the conference that established the postwar monetary order in 1944. Over the following 25 years, the dollar came to dominate global finance, trade, and banking, and nearly all foreign currency reserves were held in dollars.”
“In 1979, the United States and Saudi Arabia negotiated the United States-Saudi Arabian Joint Commission on Economic Cooperation. They agreed to use U.S. dollars for oil contracts. The U.S. dollars would be recycled back to America through contracts with U.S. companies. These companies improve Saudi infrastructure through technology transfer.”
Because Saudi/OPEC oil is a high value, global export, establishment of the petrodollar ensured large ongoing demand for US dollars. The large size and stability of the US economy relative to other economies, together with the size and liquidity of US capital markets, have continued to fortify the status of the US dollar as the global reserve currency.
- Less exchange rate risk.
- Lower interest rates: “Because other countries want to hold a currency in reserve and use it for transactions, the higher demand means lower borrowing costs through depressed bond yields (most reserves are of government bonds). Issuing countries are also able to borrow in their home currencies and are less worried about propping up their currencies to avoid default.”
- Lower interest rates often induce greater (i.e., looser) government spending by reserve country.
From McGeever, Jamie (2022, Apr 6). Column: Ebbing dollar reserves only scratch on dominance:
“Central banks and private businesses need their rainy day funds to be in liquid assets that are easily accessible, in currencies that are widely accepted and in plentiful supply, and in jurisdictions with an internationally recognized rule of law… The dollar meets all those criteria. No other currency comes close, even though the share of central bank reserves and global trade flows is increasingly being spread across a wider range of currencies…
Bank for International Settlements data show that the dollar was bought or sold in roughly 88% of global foreign exchange transactions in 2019. That has remained pretty steady over the past 20 years… About 60% of international and foreign currency liabilities and assets – primarily claims and loans, respectively – are denominated in dollars (see Figure 6). This share has remained pretty stable since 2000… On trade, around 40% of global transactions in goods are invoiced in dollars.”
From Carlsson-Szlezak, Phillipp et al (2021, Oct 7). The dollar’s dominance is far from done:
“The U.S. will retain its global heft, even if it is set to cede the top spot to China in due course. But if reserve currency status were exclusively or predominantly a matter of economic size the Chinese renminbi would have a much bigger share of global reserves. Instead, at about 2%, the renminbi has about the same share as the Canadian dollar…
In fact, the role of deep and open markets is equally important. The ability to transact and invest easily and with confidence—particularly in moments of crisis—is essential for the reserve provider. Without sizable, liquid, transparent, and open markets, a currency stands little chance of establishing itself as the key reserve currency...
Next, the credibility of institutions matters. Confidence in reserve assets is indispensable for those managing central bank reserves—they need to know that the policymakers and polity that creates, facilitates movement, and stores reserve assets will not undermine them. A solid track record of predictability dispels the risk of the assets being undermined either quickly by policy shocks or slowly through large inflation. U.S. policy credibility remains unrivaled today, and building such credibility takes time.
Geopolitics plays a role too. Reserve allocations are materially influenced by politics—specifically the geopolitics of military alliance... The U.S. enjoys a significant advantage here as its alliances are particularly intricate with large, advanced economies.”
From Burgess, Robert (2022, Mar 3). Dethroning King Dollar Won’t Be an Easy Feat:
“… [O]nly about 3% of global transactions are conducted in yuan, compared with 40% for the dollar…
The benefit to holding reserves in dollars is that U.S. markets are so much deeper and more liquid than any other…
The dollar’s share of global currency reserves has slowly eroded over the years, dropping from around 73% in 2001, but the current level is still up from the low of around 45% going back to the early 1960s…
The simple fact is, there is no alternative.”
From Richter, Wolf (2022, Apr 2). Update on US Dollar as Global Reserve Currency and the Impact of USD Exchange Rates & Inflation:
Minor Reserve Currencies (see Figure 7)
… all of the decline in the yen’s share is explained by the drop in the exchange rate of the yen against the dollar.
The fourth largest reserve currency, the British pound, has held largely level over the past few years, but with a slight upward trend in recent quarters.
The Chinese renminbi has been growing fairly consistently in minuscule increments and in Q4 reached a share of a whopping 2.8%...
The RMB, as the currency of the second-largest economy in the world, should have a larger share. But there are still problems with convertibility. While it’s freely convertible for trade purposes, there are still capital controls in effect…
Much of the reason US interest rates have been so low in recent decades (Figure 4) – despite the rapid increase in the size of the debt (Figure 5) – is the fact that the US dollar is the international reserve currency. This status has ensured strong demand for the US dollar, in spite of significant increases in the size of the debt.
It seems to me that while some nations (e.g., China and Russia) may choose to decrease their dependence on the US dollar, the lack of any real alternative means the dollar will continue to play a major role in international markets into the near future. At the same time, while still maintaining its status as international reserve, the dollar can play a larger or smaller role in international markets, depending on its strength. To the extent, then, that the US government devalues the US dollar by increasing the debt and letting inflation run rampant, foreign countries can choose use the dollar for a lessor role, rather than a more substantial one. In this case, the US dollar would lose much of the benefits of being the international reserve currency, that is, interest rates would become more sensitive to the size of the debt.