Responding to a Revaluation

Greenspan’s remarks about a possible renminbi revaluation also make me wonder exactly what the Fed would do if and when China does revalue. Mark Thoma and David Altig (among others) have had some interesting things to say about this question recently. I want to do a more in-depth treatment if these issues in the future, but for starters here are some thoughts:

• One of the dangers of end of Chinese exchange rate intervention is that interest rates in the US would spike as a result. This means that the recent lack of control over long-term interest rates that the Fed has experienced (long term rates have refused to go higher even though the Fed would probably like them to) will continue, but in the opposite direction – long term interest rates will be higher (possibly much higher) than the Fed would like. This lack of control over long-term (and maybe even medium-term) interest rates will make it difficult for the Fed to actually exercise any control over the real economy, at least for a time. This will limit the effectiveness of the Fed’s response, whatever it is.
• The biggest danger, it seems to me, is a financial meltdown in the US as the result of the spike in interest rates. It is unclear to me exactly how vulnerable the balance sheets of firms like Fannie Mae and Freddie Mac, and other large players in the bond market, are to a sharp rise in interest rates… but it strikes me as a serious possibility that some of them could be in trouble, which would have profound implications for both the US and international finacial systems. Thus the first responsibility of the Fed, I think, is to ensure that there is enough liquidity in the system to avoid a cash crunch among financial firms. I have in mind actions similar to those taken in 1998 as the LTCM affair was unfolding.
• After the initial financial shock has been absorbed, then the next most important job of the Fed retakes center stage – ensuring that inflationary expectations do not change. Since there is little doubt that inflation would indeed jump in the wake of a revaluation, the Fed therefore will face the delicate task of switching, perhaps quite rapidly, from a position of ensuring liquidity to a position of dampening incipient inflation. This, it strikes me, will be the hardest part of managing the landing for the US economy.

Will those actually running the Fed see things this way? If so, will they be up to this very formidable task? It will not be easy.

Kash