Wednesday, November 10, 2004

The Federal Reserve, citing solid growth in jobs and the economy, yesterday raised interest rates for a fourth time this year even as the dollar fell to a record low of $1.30 against the euro.

The Fed’s quarter-point increases in short-term interest rates have been aimed at stemming a pickup in inflation this year and bolstering the dollar, ensuring the United States remains an attractive place to buy and invest.

Without the flow of $1.8 billion a day in funds from overseas, the United States will not be able to continue financing its huge trade and budget deficits — a fact that Fed officials have shown a preoccupation with in recent weeks.

The dollar, which has lost 10 percent of its value against other major currencies since May, is under pressure because the trade deficit has burgeoned to more than $50 billion a month or $600 billion a year, according to a separate report from the Commerce Department yesterday.

The commerce report showed a small improvement in the deficit in September as exports soared to a record $97.5 billion and oil imports temporarily slowed as the result of hurricanes striking the U.S. Gulf Coast where tankers unload oil.

But economists say the dollar may have to fall much further — and interest rates may have to go much higher — to turn around deficits that by some estimates have grown dangerously large. At more than 5 percent of U.S. economic output, the trade deficit is at levels that have spawned financial collapses in other countries.

“The September dip is welcome but will prove temporary,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. “There is no chance the overall deficit is turning down, but the rate of increase appears to be slowing.”

Despite concern at the Fed over the ballooning trade deficit, which is abetted by federal budget deficits running over $400 billion a year, yesterday’s announcement from the Fed’s rate-setting committee did not specifically cite the deficits as a reason for higher rates.

The Fed has an even more immediate reason to be concerned about the steep decline of the dollar: It raises the cost of imports and risks sparking inflation as foreign goods from cars to computer games become increasingly expensive.

Oil prices that surged 68 percent in the last year have raised the cost of imports by nearly 10 percent, although import prices excluding oil have risen at a more tame 2.7 percent pace.

Still-low import prices, excluding oil, have helped keep U.S. consumer prices other than energy under 2 percent. But many economists expect the stubbornly higher energy prices to increasingly drive up costs for other goods and services in the months ahead.

The Fed noted that inflation remains contained, for now, and it has time to continue raising rates at a “measured” pace — language Fed-watchers interpret to mean the string of quarter-point rate increases every six weeks or so will continue.

Any sudden uptick in inflation or the trade deficit — or a precipitous drop in the dollar — might force the Fed to raise rates more aggressively, Fed watchers say.

The European currency briefly rose to a new high of $1.3007 after yesterday’s trade figures were released, breaking its old record of $1.2987. But the mark later dropped back in New York trading to $1.2895, apparently bolstered by the Fed’s action.

“People are starting to run for the exits,” said C. Fred Bergsten, director of the Institute for International Economics in Washington.

“Everyone in the market knows the dollar has to come down a lot,” not only because of the massive U.S. trade deficits but also because the United States must offset billions more in dollars sent overseas by U.S. investors and immigrants each year, he said.

While the trade deficit has been growing relentlessly for years, it suddenly came sharply into focus last week after President Bush won re-election and promised to push for partial privatization of Social Security and permanent tax-cut extensions that would only further extend the budget deficit.

Mr. Bush has promised to cut the deficit in half by the end of his second term. But the plans he laid out did not show how he would do that at the same time he enacts Social Security reforms and tax cuts that could add another $2 trillion to $3 trillion in debt.

Former Treasury Secretary Robert Rubin, who worked with Congress to balance the budget during the 1990s, this week said Mr. Bush and Congress must get serious about cutting the budget deficit or face “serious disruptions in our financial markets.”

Some economists are not as worried and believe the United States can avoid a financial collapse. Sung Won Sohn, chief economist with Wells Fargo, is hopeful that the trade gap may have peaked and is starting to turn around.

“The trade deficit has probably plateaued,” he said. “If you look at the underlying trend in deficits, hopefully the worst is over,” he said, noting that the falling dollar has made U.S. exports more competitive, causing a rising trend in exports while slowing down imports.

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