Import Prices and the Dollar

September 18, 2015

U.S. officials since the Great Recession have generally avoided engaging in currency manipulation.  Complaints were toned down about the yen and yuan being too weak.  Switzerland was given a green pass when a cap on the franc was imposed for 3+ years.  The dollar for the most part wasn’t a political football, and the dollar seldom emerged in accounts of Fed policy discussions.  The U.S. central bank faces very different conditions than the Bank of Japan, European Central Bank, or even the Bank of Canada.  Disparities have emerged in what constitutes appropriate monetary policies in these economies, and it’s been assumed as a fact of financial market life that U.S. short-term interest rates will be rising relative to other rates.

When the FOMC agreed not to start raising the federal funds rate this month, the stronger argument for delay involved the inflation mandate rather than the employment objective.  Before liftoff occurs, it’s not enough for officials to think that inflation will move back to its 2% objective over the medium term.  They need to be “reasonably confident” that the baseline forecast is correct.  Falling import prices that reflect an appreciating dollar have weakened that confidence.  Although the U.S. currency has lost over 8% against the euro and 5+% versus the yen from 2015 highs, it retains double-digit percentage advances compared to year-earlier levels against both.  Considerably larger year-over-year rises have occurred against the Russian ruble of 84%, Brazilian real of 49%, Turkish lira of 39%, Malaysian ringgit of 36%, Norwegian krone of 30%, New Zealand dollar of 27%, Australian dollar of 24%, Indonesian rupiah of 22%, Canadian dollar of 19%, Swedish krona of 18% and Polish zloty of 16%.  In the year to August, U.S. import prices tumbled 11.4% versus a drop of 0.3% in the previous 12 months and no change in the year to August 2013.  A 48.3% plunge in prices of imported fuel was the main depressant, but the strong dollar generated a 3.0% drop in non-fuel import prices.

That the dollar’s fall influenced the Fed’s decision was communicated in three ways.  Foremost, Chair-person Yellen mentioned the dollar several time in her press conference.  Second, projected inflation of the personal consumption price deflator was revised downward for both 2016 and 2017.  The PCE deflator, which is the Fed’s favored measure of U.S. inflation and which is targeted at 2.0%, rose just 0.3% in the last twelve months and at at a lower than expected annual pace of 1.2% over the past four years.  The central tendency among FOMC member predictions is now 1.5-1.8% for 2016, down from 1.6-1.9% thought in June and 1.7-1.9% forecast back in March.  The group’s central tendency for 2017 is now 1.8-2.0% versus 1.9-2.0% predicted in both June and March.  Finally, the dot-plot diagrams of where individual FOMC members think the federal funds rate ought to be at the end of 2015, end-2016, end-2017, and end-2018 exhibited another slight downward revision.  These revisions imply that policymakers are taking the effect of the dollar on inflation seriously enough as to impact their expectations of future inflation for the next couple of year and that they think this development is sufficiently meaningful as to flatten the likely path of rising interest rates, albeit marginally.

One can draw a different interpretation of why the Fed raised the matter of the dollar and import prices.  It’s terribly difficult to predict where the dollar will trade.  Movements in the dollar are one of the channels through which a change in monetary policy impacts growth and inflation.  Some central banks in the past have even targeted indices of monetary conditions, which embody both the nominal shift in the interest rates that they control and the interest-rate equivalent of currency shifts, which the marketplace decides.  I do not at all mean to suggest that the Fed is adopting such a strategy.  But by acknowledging how dollar strength can and did affect interest rate decisions by the FOMC, hesitation is introduced into investor thinking that risk surrounding the dollar is entirely one-sided in the coming period of monetary policy polarity among major advanced economies.  This is a passive-aggressive form of currency warfare.  The United States isn’t going to manipulate its currency directly, but if market forces lift the exchange rate extensively and in an ever-cumulating way, the path of Fed rate normalization will proceed in an even more gradual way than now envisaged.

As for the Fed’s other mandate of jobs growth maximization, the dip in confidence that 2% inflation can be reached as soon as assumed and then maintained can be rectified by continuing visible improvement in the U.S. labor market.  Yellen indicated that such progress has emerged faster than thought in several respects but that other areas still suggest slack.  In light of slower global growth and financial market turbulence caused by unsettled emerging economies, the tightening of the labor market could downshift a gear or two.  So the Fed wants a little more time to see if that happens and to what degree. 

Bottom line, I think Fed officials would prefer to achieve less accommodative monetary policy almost entirely through a change in interest rates and very little from additional dollar appreciation.  Policy normalization is in large part about creating scope to respond to the next recession.  The Fed controls interest rates, not the dollar.  Tying yesterday’s no-go on the fed funds rate to the implications of dollar strength is a way of modifying market psychology about the U.S. currency’s outlook heading into a widening interest rate appear for U.S. assets, a still manageable U.S. current account deficit of 2.6% of GDP, benign inflation and continuing relatively attractive economic growth.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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