Federal Reserve officials are finding it harder than they firstthought to decouple U.S. monetary policy from the rest of theworld.

While policy makers opened the door to an interest-rate increaselater this year, Fed Chair Janet Yellen suggested they were in nohurry and said the pace of tightening, once begun, would be slowerthan previously anticipated.

Behind the wary stance: a surge in the dollar, triggered in partby easier monetary policies abroad. The dollar's strength isrepressing already too-low U.S. inflation while restrainingeconomic growth.

“In today's interconnected world, it was probably a little naïveto believe the U.S. would be totally immune to global pressures,”said Chris Rupkey, chief financial economist at Bank ofTokyo-Mitsubishi UFJ Ltd. in New York. “Maybe every other centralbank in the world cutting rates made them rethink their plans to goit alone.”

U.S. stock and bond prices rallied Wednesday while the dollarsank in response to the statements from Yellen and the Fed. TheStandard & Poor's 500 surged 1.2 percent, while the yield on10-year Treasury notes sank 13 basis points to 1.92 percent. TheBloomberg Dollar Spot Index dropped 1.8 percent.

The Federal Open Market Committee dropped an assurance in itspolicy statement that it will be “patient” in tightening policy,raising the possibility of its first rate increase in almostdecade. Yellen though stressed at a press conference that thechange did not mean the Fed was in a rush to raise rates.

“Just because we removed the word patient from the statementdoesn't mean that we're going to be impatient,” she said.

Money-market futures traders cut the odds of a rate increasebelow 50 percent until December.

While the removal of the patient pledge was widely anticipated —Yellen herself foreshadowed the move in congressional testimonylast month — what surprised Fed watchers was a ratcheting down ofinterest rate projections by central bank policy makers.

Officials lowered their median estimate for the federal fundsrate at the end of 2015 to 0.625 percent, compared with 1.125percent in December forecasts. The median estimate for the end of2016 declined to 1.875 percent from 2.5 percent. The current targetfor the funds rate — the rate that banks charge each other forovernight money — is zero to 0.25 percent.

Dollar's Role

“It was hard to justify that kind of revision based simply onthe economics,” Michael Feroli, chief U.S. economist at NewYork-based JPMorgan Chase & Co. and a former Fed researcher,said in a Bloomberg Television interview. “It does look like therewas something else seeping in there. I'm sure the dollar was afactor.”

The Bloomberg Dollar Spot Index, which tracks the U.S. currencyagainst 10 major peers, has climbed more than 18 percent since themiddle of last year as the Fed has signaled its intention to raiserates this year while the European Central Bank and the Bank ofJapan have acted to aggressively ease monetary policy.

The currency's strength affects the economy in two main ways: Itholds back economic growth by reducing the competitiveness of U.S.exports while depressing inflation by pushing down importprices.

Not only is the dollar's rise reducing price pressures, makingit harder for the Fed to tighten, it's also acting as an “economicheadwind reducing the need to tighten,” said Lou Crandall, chiefeconomist at Wrightson ICAP LLC in Jersey City, New Jersey.

The FOMC made a nod to the dollar's impact on the economy in itspolicy statement, noting that export growth has weakened. Yellenwas more explicit in her press conference, saying that exportswould be a “notable drag” on growth this year and tying that to thestrength of the dollar, which she said partly reflected thestrength of the U.S. economy.

Yellen said the currency's rise was also “holding down importprices and, at least on a transitory basis at this point, pushinginflation down.”

“The Fed sees the stronger dollar as effectively tighteningconditions in the U.S.,” said Jonathan Wright, a professor at JohnsHopkins University in Baltimore and a former economist at the Fed'sDivision of Monetary Affairs. “They are worried about what willhappen to the dollar and financial markets when the Fed startstightening with much of the rest of the world at negative interestrates.”

Inflation Confidence

Yellen said it will be appropriate to raise rates “when thecommittee has seen further improvement in the labor market and isreasonably confident that inflation will move back to its 2 percentobjective over the medium term.”

Inflation as measured by the Fed's preferred gauge was just 0.2percent in January and has languished below the central bank'starget for 33 straight months.

The labor market in contrast has been strong. Surging job gainspushed unemployment down to 5.5 percent in February, the lowestlevel in almost seven years.

Wage gains though have been meager — something that Yellenpointed to as indicating there's still slack in the labor market inspite of the continued fall in the jobless rate. Perhaps inresponse, Fed policy makers revised their estimate of whatconstitutes full employment. Most now think that's equivalent to a5 percent to 5.2 percent unemployment rate, down from the 5.2percent to 5.5 percent range they had in December.

Officials also marked down their economic growth forecasts. Mostnow see the economy expanding 2.3 percent to 2.7 percent this yearand next. In December, they had forecast growth of as much as 3percent in both years.

Yellen argued that the economy still had “underlying strength”despite the trimmed projections by the FOMC. “This is not a weakforecast,” she said. “We continue to project above-trend growth. Wecontinue to project improvement in the labor market.”

While the dollar's rise is acting as a drag on growth, otherforces are boosting it, including the steep drop in energy prices,she said.

Still, Yellen has shown that she “will take dollar strength intoaccount in calibrating rate strategy,” Krishna Guha, a former Fedofficial who is now vice chairman of Evercore ISI in Washington,said in a note to clients. “That is good news for risk assets ingeneral.”

Bloomberg News

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