Federal Reserve officials are finding it harder than they first thought to decouple U.S. monetary policy from the rest of the world.
While policy makers opened the door to an interest-rate increase later this year, Fed Chair Janet Yellen suggested they were in no hurry and said the pace of tightening, once begun, would be slower than previously anticipated.
Behind the wary stance: a surge in the dollar, triggered in part by easier monetary policies abroad. The dollar’s strength is repressing already too-low U.S. inflation while restraining economic growth.
“In today’s interconnected world, it was probably a little naïve to believe the U.S. would be totally immune to global pressures,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “Maybe every other central bank in the world cutting rates made them rethink their plans to go it alone.”
U.S. stock and bond prices rallied Wednesday while the dollar sank in response to the statements from Yellen and the Fed. The Standard & Poor’s 500 surged 1.2 percent, while the yield on 10-year Treasury notes sank 13 basis points to 1.92 percent. The Bloomberg Dollar Spot Index dropped 1.8 percent.
The Federal Open Market Committee dropped an assurance in its policy statement that it will be “patient” in tightening policy, raising the possibility of its first rate increase in almost decade. Yellen though stressed at a press conference that the change did not mean the Fed was in a rush to raise rates.
“Just because we removed the word patient from the statement doesn’t mean that we’re going to be impatient,” she said.
Money-market futures traders cut the odds of a rate increase below 50 percent until December.
While the removal of the patient pledge was widely anticipated — Yellen herself foreshadowed the move in congressional testimony last month — what surprised Fed watchers was a ratcheting down of interest rate projections by central bank policy makers.
Officials lowered their median estimate for the federal funds rate at the end of 2015 to 0.625 percent, compared with 1.125 percent in December forecasts. The median estimate for the end of 2016 declined to 1.875 percent from 2.5 percent. The current target for the funds rate — the rate that banks charge each other for overnight money — is zero to 0.25 percent.
“It was hard to justify that kind of revision based simply on the economics,” Michael Feroli, chief U.S. economist at New York-based JPMorgan Chase & Co. and a former Fed researcher, said in a Bloomberg Television interview. “It does look like there was something else seeping in there. I’m sure the dollar was a factor.”
The Bloomberg Dollar Spot Index, which tracks the U.S. currency against 10 major peers, has climbed more than 18 percent since the middle of last year as the Fed has signaled its intention to raise rates this year while the European Central Bank and the Bank of Japan have acted to aggressively ease monetary policy.
The currency’s strength affects the economy in two main ways: It holds back economic growth by reducing the competitiveness of U.S. exports while depressing inflation by pushing down import prices.
Not only is the dollar’s rise reducing price pressures, making it harder for the Fed to tighten, it’s also acting as an “economic headwind reducing the need to tighten,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.
The FOMC made a nod to the dollar’s impact on the economy in its policy statement, noting that export growth has weakened. Yellen was more explicit in her press conference, saying that exports would be a “notable drag” on growth this year and tying that to the strength of the dollar, which she said partly reflected the strength of the U.S. economy.
Yellen said the currency’s rise was also “holding down import prices and, at least on a transitory basis at this point, pushing inflation down.”
“The Fed sees the stronger dollar as effectively tightening conditions in the U.S.,” said Jonathan Wright, a professor at Johns Hopkins University in Baltimore and a former economist at the Fed’s Division of Monetary Affairs. “They are worried about what will happen to the dollar and financial markets when the Fed starts tightening with much of the rest of the world at negative interest rates.”
Yellen said it will be appropriate to raise rates “when the committee has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”
Inflation as measured by the Fed’s preferred gauge was just 0.2 percent in January and has languished below the central bank’s target for 33 straight months.
The labor market in contrast has been strong. Surging job gains pushed unemployment down to 5.5 percent in February, the lowest level in almost seven years.
Wage gains though have been meager — something that Yellen pointed to as indicating there’s still slack in the labor market in spite of the continued fall in the jobless rate. Perhaps in response, Fed policy makers revised their estimate of what constitutes full employment. Most now think that’s equivalent to a 5 percent to 5.2 percent unemployment rate, down from the 5.2 percent to 5.5 percent range they had in December.
Officials also marked down their economic growth forecasts. Most now see the economy expanding 2.3 percent to 2.7 percent this year and next. In December, they had forecast growth of as much as 3 percent in both years.
Yellen argued that the economy still had “underlying strength” despite the trimmed projections by the FOMC. “This is not a weak forecast,” she said. “We continue to project above-trend growth. We continue to project improvement in the labor market.”
While the dollar’s rise is acting as a drag on growth, other forces are boosting it, including the steep drop in energy prices, she said.
Still, Yellen has shown that she “will take dollar strength into account in calibrating rate strategy,” Krishna Guha, a former Fed official who is now vice chairman of Evercore ISI in Washington, said in a note to clients. “That is good news for risk assets in general.”