Federal Reserve chair Janet Yellen and her colleagues have so far found themselves wrong-footed by the stronger dollar after they raised interest rates last month for the first time since 2006.
In spite of suggestions by some officials that the US currency’s rise would soon run out of steam, the dollar has appreciated by some 2% since the central bank last met on December 16, measured on an effective exchange rate-basis. Coming on top of a 11% increase in the year prior, the latest advance will curb already slowing economic growth and put downward pressure on an inflation rate that the Fed judges is too low as it is.
“It’s a big move in a month,” said Robert Mellman, a senior US economist at JPMorgan Chase & Co in New York, adding that was a key reason why the bank recently pushed back its forecast of the Fed’s next rate rise to June from March. “The cumulative effects of a stronger dollar on the economy and inflation are substantial.”
Yellen and her fellow officials are almost universally expected to hold rates steady at their first gathering of the year on Tuesday and Wednesday. Investors though will be scouring the statement released afterward for hints that the Fed is backing away from its base case of four quarter percentage-point rate increases in 2016.
The US central bank said on Monday that the meeting will go ahead in spite of a severe winter storm that has disrupted travel to and from Washington. Policy makers from outside the city unable to attend in person will be take part via video conference.
This year’s bout of turbulence on world financial markets - the dollar and Treasury debt prices have surged while equity and commodity prices have plunged - has prompted investors to scale back their expectations of Fed action. They now see at most only two rate hikes this year and put the odds of March move at 26%. That’s down from 46% this time last month, according to trading in the federal funds futures market.
When the Fed last confronted unsettled financial markets and an uncertain global economic outlook in September, it postponed an expected rate increase and said it was “monitoring developments abroad.” After markets calmed down, policy makers boosted rates in December, with Yellen extolling the strength of the domestic economy in comments to reporters after the decision.
Morgan Stanley & Co economists in New York expect the Fed to again give a nod to international and market concerns in their statement this week, but without closing the door to a March rate increase.
Yellen will not be holding a press conference after this week’s meeting. She will though get a chance to more fully explain the Fed’s thinking when she appears before the House Financial Services Committee on February 10 to deliver the central bank’s semi-annual report to Congress.
In a speech on November 12, Fed vice chairman Stanley Fischer said computer calculations by the central bank show that a 10% rise of the dollar lowers US gross domestic product by more than 1.5% after three years, mainly by reducing exports.
GDP is projected to have grown by just an annualised 0.8% in the fourth quarter, according to the median forecast of economists polled by Bloomberg. The government is scheduled to release the numbers tomorrow.
A dollar rise also temporarily reduces inflation by lowering the price of imports, Fischer said. Fed calculations suggest that a 10% appreciation depresses core inflation by about 0.3% over a year. Core inflation, which excludes volatile food and energy costs, stood at 1.3% in November from the prior year, well below the Fed’s 2% goal.
In separate comments earlier this month, St Louis Fed president James Bullard and San Francisco Fed president John Williams both suggested that they did not anticipate a major increase in the greenback in the future. “I wouldn’t expect a lot of appreciation in the dollar going forward, because markets have already priced in what is going to happen with relative monetary policy” in the US and Europe, Bullard said in Memphis, Tennessee, on January 14.
The currency’s latest rise though has come not so much against the euro, but against the currencies of commodity exporters such as Canada and Asian nations that are suffering the fallout from slower Chinese demand, JPMorgan’s Mellman said.
Movements in the US currency are the most important thing to watch in determining the pace of Fed rate rises in 2016, according to Michael Salm, co-head of fixed-income at Putnam Investments LLC in Boston.
“When the dollar rises, it slows things down, it’s a form of tightening on its own,” he said. “The single, most-important macro global indicator this year is the dollar.”