Act one of the drama gripping the US economy featured subprime mortgages. Act two – which was all about house prices, asset-backed commercial paper and the three-month Libor rate – came to a spectacular end last week when the Federal Reserve cut interest rates by an aggressive 50 basis points. Act three will be about the dollar. If low interest rates cause foreign investors to lose confidence in the US currency then the chance of recession in the world’s largest economy will rise.

Ben Bernanke, Fed chairman, and his board of governors will look at the market reaction to their rate cut with trepidation. Shares bounced. Short-term interest rates fell – although the squeeze on bank liquidity has not yet been resolved. That is all as expected.

What will worry Mr Bernanke is the rise in long-term interest rates – yields on Treasury bonds maturing in 10 or 30 years rose – and a sharp 1.5 per cent fall in the dollar’s effective exchange rate in the space of only a few days.

The rise in long-term interest rates may reflect expectations that the Fed’s rate cut will stabilise the economy, growth will rebound, and rates will therefore not have to go as low as they might have done. A more plausible explanation is fear of inflation. Either way, it is deeply unhelpful to the Fed. Mortgages are linked to long-term rates more often than to base rates. It is possible that the cost of some new mortgages will rise because of the Fed’s cut.

A decline in the dollar would be welcome if it was slow, but if foreign investors anticipate inflation and start to dump some of their $12,000bn in US debt, it could turn into a rout. In the worst case the Fed would lose some control of monetary policy, with long-term rates responding to foreign selling no matter what the Fed did at the short end, and the economy plunged into recession.

The declining dollar will have other repercussions around the world. The rise in the euro’s effective exchange rate has been almost as fast as the dollar’s fall. Europe’s businesses and politicians – stung by lost export competitiveness – will demand lower interest rates to compensate. The European Central Bank will be reluctant to oblige.

All those Asian countries that peg their currency to the greenback – either implicitly or explicitly – also have a problem. China will either have to buy dollars even faster than its present, unsustainable rate, or let the renminbi rise, and take a huge loss on its existing reserves.

A dollar slump is only one of a number of possible scenarios. But when making aggressive rate cuts to reduce the chances of recession, Mr Bernanke and the Fed must not forget that the US is a net debtor to the rest of the world, and in that position inflation-fighting credibility is an essential, not a luxury. The danger to the dollar is an important concern and further cuts to US interest rates should be measured.

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