The Federal Reserve: Ignoring the Global Economy?
The Federal Reserve has been accused, among many other things, of ignoring the global economy. Vice Chairman Stanley Fischer would beg to differ. In a speech in early October he delivered to the International Monetary Fund, Fischer was straightforward in his claim the Fed does incorporate global economic outcomes into its analysis. And this is a good thing—more than that, in a world where the US dollar dominates the financial landscape—it is a must.
Recent days have seen the Bank of Japan surprise everyone with a large quantitative easing package, the European Central Bank attempting to spur economic growth and inflation in the Eurozone (the ECB has begun buying asset backed securities), and China cutting rates to stem their economic slowdown. Even so, few are discussing how the Fed should react.
The Fed, when it ended Quantitative Easing (QE), handed the direction of the global economy to other central banks. If the world’s central banks become increasingly loose with their monetary policy, the discussion shifts from the unintended consequences of Fed policy to the possible outcomes based on the decisions of the rest of the central banks. The Fed’s policy of QE may inspire other central banks to undertake similar actions. But their intentions tend less toward domestic economic health and more toward global currency competitiveness.
Some countries may argue that this is not unlike what the US did for the past decade or so. To deconstruct Fischer’s statement in this context: 1) the Fed is concerned about the potential spill-over effects of its policy (both during and after its implementation) in the currency and bond markets, 2) The Fed should step in to do something if it is necessary for global financial stability and therefore the US economy, 3) which is part of the Fed’s mandate.
How does the Fed plan to fulfill its mandate in light of the previously mentioned unanticipated moves by other central banks? It’s tricky. While the Fed may have lost control of the dollar’s short-term destiny—it may strengthen regardless of what actions they take, there is hope that the Fed can “forward guide” the dollar over time. The Fed is obviously aware and ready to counteract the effects of its choices on the rest of the world. But is it ready to counteract the effects of the rest of the world on the US?
The rest of the world’s decisions—especially those of the larger central banks—directly affects economic outcomes in the US. And the Fed is paying attention. Fischer said as much, “In determining the pace at which our monetary accommodation is removed, we will, as always, be paying close attention to the path of the rest of the global economy and its significant consequences for U.S. economic prospects.”
But the Fed is unlikely to base policy on such considerations—at least until things get out of control and begin to influence economic outcomes. This shifts the Fed from a proactive US data and potential outcomes stance to a reactive stance based on foreign central bank moves.
The problem is that it will be difficult to stem to the shift once it begins. If the Fed reacts weakly—or not at all—the markets will take it as a sign that the dollar is being allowed to strengthen. A strong dollar jeopardizes many of the positive US growth stories. It makes the US less competitive globally in manufacturing. Lower transport costs (due to low oil prices) further weakens it. As cheaper goods begin to flow into the country from abroad, prices are held down—and thus the US imports deflation. What the rest of the world does—especially the three central banks currently taking action—has real, tangible effects on the US. The consequences, which will affect US competitiveness and global commodity prices, threaten to dislodge market participants’ faith in the Fed’s ability to stem deflation. These are unlikely to remain theoretical concepts.
So, in the post-QE era, the Fed must shift its focus from internal forces to external ones. With particular attention to the big three central banks, and the spillover effects their policies have here. According to Fischer, this should not worry onlookers. He was more concerned with the US effect on economies abroad, not their effect here. But this might be wishful thinking. And he left the door open to taking the global economy into account when determining policy—even stating that global financial stability was consistent with the Fed’s mandate.
With Fischer looking abroad at spillover effects and Yellen looking internally at inequality, the Fed’s mandate is evolving into a far more encompassing goal. Much of the time the goals intertwine. The times when they do not are when policy becomes increasingly difficult to manage. The Fed has relinquished the lead in global easing for the moment. The US may not be able to afford a stronger dollar and the loss of competitiveness for long without suffering some loss of credibility. In his speech Fischer cited the economist Charles Kindleberger’s theory that the global economy would benefit from a hegemonic central bank. Fischer retreated from this idea, insisting the Fed did not view itself this way. But maybe it should. The dollar is the world currency, and the Fed cannot afford to lose control of it.
Samuel Rines is an economist with Chilton Capital Management in Houston, TX. Follow him on Twitter @samuelrines.
Image: Flickr/Creative Commons.