As we approach the eighth year since the start of the Great Recession, there’s little sign that monetary policy has returned to normal. No major central bank has raised policy rates in close to a decade and bond yields worldwide remain “low” by any normal measure.
Policy rates in inflation-adjusted terms are negative across most developed countries, and in some places, nominal base rates themselves are negative (Switzerland, for example.) While quantitative easing has come to a close in the U.S. and the U.K., asset purchases continue in earnest from other central banks including the ECB (which is buying a set amount of assets per month) and the BoJ (which is targeting a set increase in the monetary base for “as long as it is necessary.”) With dampened inflation pressures globally resulting from low oil prices and in some cases, soft import prices as a result of currency strength, is it really time for a rate rise in the U.S., particularly if the rest of the world continues to see weak growth prospects ahead? Why do 13 of 17 Federal Reserve Board members expect “policy firming” this year?
Nominal exports as a percentage of nominal GDP growth in the US have risen from 9.8% in 1980 to 13.5% in 2014, so external growth is an important source of U.S. GDP growth. However, analysis from the Federal Reserve Bank of New York shows that a 10 percent appreciation of the U.S. dollar in one quarter shaves just 0.5 percentage point off GDP growth over one year and an additional 0.2 percentage point in the following year if the strength of the dollar persists once the impact on exports—as well as imports are considered. While this decline is not trivial, a 0.7 percentage point pullback in growth over two years is unlikely to thrust the U.S. back into recession. However, would further dollar appreciation be sufficient for persistent deviation from the Fed’s 2% inflation target?
Possibly, especially if monetary policy tightening provokes capital flows that serve as the catalyst for further dollar strength. From July 2014 through March 2015, the real dollar effective exchange rate index rose by almost 12%. But over the same period, import price inflation less petroleum fell by a cumulative 1.8% even as CPI less energy rose (albeit at a slower rate) by a cumulative 1.2%, suggesting that weaker import prices are only one factor affecting overall inflation.
Longer-term inflation break-evens have begun to stabilize, with the Fed’s measure of 5-year inflation 5 years forward rising to 2%, after falling below 1.80% in September. Importantly, in a September speech on inflation, Chair Yellen highlighted that the restraint on inflation imposed by economic slack is now relatively modest, estimating that such slack has been responsible for only 0.1 to 0.2 percentage points of downward pressure on inflation this year, versus a 0.5-0.6 percentage point drag during 2008-2013. Against this backdrop and amid an environment of firmer wages, it would be a mistake for the Fed to delay a rate hike due to concerns over further U.S. dollar strength.