Yellen’s Speech Today and the Dollar Outlook

June 6, 2016

The Fed Chair’s speech in Philadelphia today did not depart significantly from her previous comments on the U.S. economic outlook, risks to the baseline forecast, and how Fed policy might evolve from here.  One apparent change, which markets already had concluded, is that a federal funds rate hike to 0.50% at next week’s FOMC meeting appears very remote in the wake of last Friday’s disappointing Labor Department jobs report for May.  Fed officials will require more data to interpret that news as statistical noise or an enduring slowdown in employment growth and, it that is the case, to learn more about the reason for the slowdown and what such foreshadows about future consumption and business investment.

The medium-term outlook still projects continuing progress toward meeting both Fed mandates on labor market conditions and inflation, and the policy inference to draw from that view still foresees a gradual rise in Fed-controlled interest rates in the context of a normalizing process.  In questions and answers, Yellen stressed that rate normalization is not a third policy goal added to its two mandates from the Congress.  A “normal” inflation-adjusted fed funds rate, for one thing, is a contextual concept rather than a fixed, unchanging level at all times.  Under most scenarios including the Fed’s baseline forecast, the 0.25% current target appears a bit low, and the appropriate interest rate should move higher as progress is made toward the inflation target and the achievement of fuller utilization of productive labor.  The point was also made that the path toward greater rate normalization is likely to be lower and peak at a much lower eventual point that has been true of previous rate tightening cycles.  A factor Yellen did not mention but which I consider to be a key motivator of the desire to raise interest rates is to create leeway to boost aggregate demand in the U.S. economy by cutting interest rates when a cyclical need for stimulus next arises.  Finally, in response to a different question, she acknowledged the potential for negative effects in the long run of maintaining ultra-low interest rates from a prolonged period.

A bigger question regarding future Fed policy than what Federal Open Market Committee members would like to enact over the balance of 2016 and beyond is what the U.S. economy can indeed handle.  Three factors are working against the FOMC getting all that it wants, and two of them are out of the committee’s control.  One is the political mood in Washington against fiscal stimulus of any sort, and the other is the fragility of the world economy.  The third matter concerns the failure thus far of any of the major advanced economy that resorted to a zero or near-zero interest rate policy (ZIRP) in the aftermath of the Great Recession to tolerate a normalizing interest rate cycle afterward.  The reason for this intolerance may simply underscore the extent of the systemic shock absorbed by the financial crisis and need for a decade or so to recover amply to permit rate normalization.  This call for patience and time to heal is not very compelling.  Just as we know that business upswings do not die of old age, there is no reason to expect a span of ample time at very low interest rates to produce enough healing for rates to rise without risk.  The other possible explanation is that ZIRP represents a kind of policy black hole from which one cannot escape.  If any economy is going to achieve escape velocity, one would expect it to be the United States because of its great flexibility and comparatively favorable demographics.  So far, however, the journey has been frustratingly slow even for the United States.

Having said all that, the connection between Fed rate normalization and the dollar’s performance against other currencies is much less straight-forward than generally perceived.  Between the initial federal funds hike announced last December 16 and May 27, the trade-weighted dollar fell 3.8% against currencies that trade widely outside the country of issue, but trade-weighted depreciation against U.S. trading partners was much shallower at 0.6%.  Since the fed funds rate went up 25 basis points, the 10-year Treasury yield has fallen nearly a half percentage point.  A rule of thumb that translates the impact of a change in a trade-weighted currency to a change in central bank rates that would produce an equivalent impact on economic growth and inflation is to take the reciprocal of the import/GDP ratio.  U.S. imports constitute almost 15% of GDP, so a 3.8% trade-weighted slide in the dollar is like a 50-60 basis point drop in short-term interest rates.  But a 0.6% trade-weighted dollar dip is like an insignificant 10 basis point drop in interest rates.  Net exports have indeed contributed negatively to U.S. growth but not to a quantifiable large degree.

The lessons one needs to take from this are

  1. The dollar’s level, its recent movement, and how it might be affected by a second fed funds hike are not going to influence the timing of a second tightening.
  2. The second rate hike may not lift the dollar in an enduring way.  The Fed is proceeding too slowly and from too low a level to dictate the dollar’s trend.
  3. Unless data depicting a cumulatively worrisome picture of U.S. economic growth in the second quarter and early summer emerges, officials will want to seize the moment in July when they meet on the 27th.  Britain’s referendum will be out of the way, and the ensuing two scheduled opportunities to raise rates on September 21 and November 2 fall during the general election campaign.
  4. If the Fed manages to enact two increases in calendar 2016, July 27 and December 14 offers the likeliest combination of dates from where I sit.  If only one move is possible, December 14 seems to fit the prescribed needs best.
  5. One should not over-emphasized Fed policy in deciphering future dollar movement.  That connection wasn’t a particularly good guide over the past half year.  Moreover, the dollar isn’t moving the same way against all currencies.  Since May 27, its fallen 2.7% against the yen but risen 2.2% against the euro.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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