When viewed in the context of the FOMC’s mandate to deliver “maximum employment, stable prices, and moderate long-term interest rates,” the current fed funds rate appears unnecessarily low. The U.S. economy is 11% larger than it was in December 2007, the unemployment rate is below 5% and inflation is rising towards the FOMC’s 2% target. Relative to its global peers, the performance of the U.S. economy has been exemplary. Real GDP in the U.S. regained its pre-financial crisis level more than two years before its next closest peer, the U.K. Inflation is closer to target than other large developed economies, and price momentum is on firmer footing.
What this observation doesn’t reveal is the fact that the Fed’s approach to policy has evolved over the last nineteen months and now incorporates significant emphasis on the effects that “international developments” have on domestic growth and inflation. It is now widely understood that exogenous forces have been the swing factor preventing the FOMC from normalizing policy despite domestic conditions that warrant it. This notable shift in the Fed’s worldview highlights how global central banks have adapted since the financial crisis, but also the fact that the global economy and capital markets are highly integrated.
When the FOMC concluded QE in October 2014, the domestic economy was solid (unemployment was falling rapidly, payrolls were averaging over 200k, and headline CPI was 1.7%) and the Fed expected to eventually raise rates to 3.75%. When describing the variables that would be considered in determining when to start tightening policy, nondomestic factors were absent from the discussion. Since then, however, FOMC communications have transformed and now indicate an acute awareness of the impact that U.S. monetary policy can have on global financial conditions and the feedback loop that can transmit international weakness back to the U.S. This has forced the FOMC to recalibrate to a more cautious approach.
In January 2015, with the dollar strengthening and inflation expectations plummeting, the FOMC upgraded its assessment of the U.S. economy, but for the first time noted that it would be taking into account “international developments” when deciding when to begin raising rates. In September 2015, the FOMC put its hiking plans on hold as a result of market volatility sparked by China’s currency devaluation. That month’s FOMC statement contained the key phrase, “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”. The Committee stated that risks to its outlook were balanced, but it was watching “developments abroad” for any signs to the contrary. Importantly, these changes occurred without any meaningfully shift in the Fed’s economic assessment of the U.S. The FOMC (finally) went on to hike in December as global markets stabilized.
In January 2016, as volatility picked up again, the FOMC removed its appraisal of the balance of risks to its outlook and explicitly linked its assessment to global developments by saying, “the Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook”.
Later in February, Fed Governor Lael Brainard delivered a speech titled “What Happened to the Great Divergence?” in which she highlighted the risks of policy divergence in a world of low growth and inflation by suggesting that “With intensified transmission effects in the vicinity of the zero lower bound, there is a risk that uncoordinated policy on its own could have the effect of shifting demand across borders rather than addressing the underlying weakness in global demand…This might be a good time for policymakers to reaffirm their commitment to work toward the common goal of strengthening global demand.”
Less than a week ago, New York Fed President Bill Dudley expressed a similar opinion by saying,
“…when I reiterate that U.S. monetary policy is data dependent, that includes not just the information gleaned from important economic releases…, but also how financial market conditions react to economic and financial market developments in the global economy…what we do in the United States has an impact far beyond our borders, and we need to take that into consideration in how we conduct and communicate monetary policy in the United States.”
The implications of the FOMC’s shift in reaction function are manifold: (1) domestic growth and inflation aren’t the only inputs into the FOMC’s decision making process; (2) the Fed is more likely to take a cautious approach to normalizing policy when the global backdrop is uncertain, even if confronted with higher U.S. growth and inflation; and (3) more globally integrated markets, synchronized by their heavy reliance on the dollar, increase the chances that global spillovers will negatively impact the U.S. economy. These three factors make it more likely that the FOMC will be less responsive to stronger-than-expected domestic data and will wait for a more conducive global backdrop before reengaging a less cautious approach to monetary policy.