Research article

Will The US Continue To Zig?

Heidi Learner explains why further monetary tightening may be likely in the US.

As we approach the eighth year since the start of the global financial crisis, there is little sign that monetary policy has returned to normal, even with the recent announcement by the Federal Reserve to raise rates by 0.25% to 0.5%. No other major central bank has raised rates in close to a decade and bond yields globally remain ‘extremely low’ (see fig. 1). Inflation-adjusted policy rates are negative across most developed countries and in some places, such as Switzerland, even nominal base rates are negative.

Figure 1

FIGURE 1Looser monetary policy everywhere

Sources: Bloomberg

Quantitative easing may have come to an end in the US and the UK, but asset purchases by other central banks continue. The European Central Bank is buying a set amount of assets per month, while the Bank of Japan is targeting a set increase in the monetary base for as long as necessary. Low oil prices and, in some cases, currency strength and soft import prices, have dampened global inflation pressures and the rest of the world continues to foresee weak growth prospects. Yet in the US, all 17 Federal Reserve Board members expect further ‘policy firming’ in 2016. Was the time really right for a rate rise?

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 US GDP growth. However, export growth can be damaged by a strong dollar. Analysis from the Federal Reserve Bank of New York shows that when the impact on exports and imports is considered, a 10% appreciation of the US dollar in one quarter shaves 0.5 percentage points off GDP growth the next year. If the strength of the dollar persists, an additional 0.2 percentage point reduction occurs in the subsequent year, too. While this decline is not trivial, a 0.7 percentage point pullback in growth over two years is unlikely to thrust the US back into recession. Would further dollar appreciation be enough for the Fed to persistently deviate from its 2% inflation target and avoid further rate rises?

This is possible if monetary tightening provokes an upward spiral of capital flows that serves as the catalyst for further dollar strength. The strong dollar does not appear to be curbing domestic inflation away from the transmission of oil prices. From July 2014 to March 2015, the real dollar effective exchange rate index rose by almost 12%. Over the same period, import price inflation (less petroleum) fell by a cumulative 1.8% (see fig. 2). But the US CPI (less energy) rose by a cumulative 1%. This suggests that lower import prices are a minor factor affecting inflation.

Figure 2

FIGURE 2Strong dollar impacts on US inflation have weakened, freeing the Fed to hike base rates

Sources: BLS/Federal Reserve

In November, the CPI for all items (less food and energy) rose 2%, the largest 12-month increase since May 2014. Most categories in the service sector have shown acceleration over the past three months versus the past 12 months, suggesting that inflation pressures may be brewing.

Longer-term inflation breakevens have begun to stabilise, even though the Fed’s measure of five-year inflation remains close to post-recession lows. Importantly, the Fed’s Chair, Janet Yellen, recently highlighted in a speech that the restraint on inflation imposed by economic slack is now relatively modest. It would have been a mistake for the Fed to delay a rate hike due to concerns over further US dollar strength, especially given policy lags.

We believe that a very slow return to more normal monetary conditions has now begun in the US and will continue in 2016, with implications for central banks around the globe.

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