The Federal Reserve is truly facing a quandary. The U.S. economy is weak and getting weaker but if the Fed lowers its discount rate, it will fan the inflationary infernos building in China, India and other emerging countries that peg their exchange rates to the U.S. dollar (as part of their industrialization strategies based on maintaining export competitiveness). They presently have annual inflations rates greater than 8% but their central banks would still be constrained to follow U.S. rates down in order to maintain the currency peg.
At some point, China, India, and the other emerging countries with managed currencies will find their economies are getting too far out of line and may decide to give up their currency pegs. That means they will have less need to accumulate U.S. dollars. And lower demand for U.S. money could bring the world closer than ever to the long-feared run on the U.S. dollar. Similarly, there will be pressures on U.S. long-term interest rates to rise sharply since foreign countries will have relatively lower U.S. dollar reserves to plow into U.S. treasuries.
Things appear to be different from the 2001-2002 period. It is unlikely the same result — the mildest of recessions — will be the result. This time around the Fed has less freedom of action. The result will likely be a more substantial downturn. The stream of economic reports could be getting a lot uglier from here on in.