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Thursday, March 12, 2015

Fed Watch: Will the Dollar Impact US Growth?

Tim Duy:

Will the Dollar Impact US Growth?, by Tim Duy: A quick one while I wait for my flight at National. Scott Sumner argues that the strong dollar will not impact US growth. In response to a Washington Post story, he writes:

This is wrong, one should never reason from a price change. There are 4 primary reasons why the dollar might get stronger:

1. Tighter money in the US (falling NGDP growth expectations.)
2. Stronger economic growth in the US.
3. Weaker growth overseas.
4. Easier money overseas.

In my view the major factor at work today is easier money overseas. For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

The initial point is correct - arguing from a price change is a risky proposition. Go to the underlying factors. But I think the next paragraph is a bit questionable. I think that the policy shift in Europe does reduce tail risk for the global economy, and is therefore a positive for the US economy (I suspect the Fed thinks so as well). But it reduces tail risk because ECB policy is supporting not one but two positive economic shocks - both falling oil and a rising falling Euro. And, all else equal, a rising falling euro means a stronger dollar, which means a negative for the US economy. Tail risk for Europe is reduced at a cost for the US economy (a cost that the Federal Reserve and US Treasury both seem willing to endure).

That said, all this means is that Sumner is right, you can't reason from a price change, but reasoning in a general equilibrium framework is very, very hard. Sumner gets closer here, but still I think falls short:

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions. Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market. But that’s still a few years away. Nonetheless, let’s assume Hypermind is correct. Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit. But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

So let's try to close the circle - not only can't you reason from a price change, but also you need to pay attention to the entire constellation of prices. If ECB policy - and, by extension, the falling euro - was a net positive for the US economy, shouldn't we expect higher long US interest rates? But long US rates continue to hover around 2%, which seems crazy given the Fed's stated intention to start raising rates. Consider, however, that the stronger dollar does in fact represent tighter monetary conditions, but long interest rates are falling, which acts as a counterbalance by loosening financial conditions. Essentially, markets are anticipating that the stronger dollar saps US growth, but the Fed will respond with a slower pace of policy normalization, which acts in the opposite direction. So the stronger dollar does negatively impact growth, but market participants expect a monetary offset.

Hence - and I think Sumner would agree with this - the ball is in the Federal Reserve's court. The stronger dollar is a negative for the US economy, while the expected impact on monetary policy is a positive. The net impact is neutral. You should anticipate a stronger domestic economy offset by a larger trade deficit.

That is, of course, assuming the Federal Reserve takes sufficient note of the rising dollar, and its impact on inflation, by lowering the expected path of short term interest rates. And perhaps this is exactly what is revealed in next week's Summary of Economic Projections. Look for the possibility next week that the Fed is both hawkish - by opening the door for a June hike - and dovish - by lowering the median rate projections in the dot plot.

Update: I see Paul Krugman is lamenting the possibility that some FOMC members interpret falling interest rates as reason to tighten policy more aggressively - a view primarily outlined by New York Federal Reserve President William Dudley. My read of the bond market implies that market participants expect the opposite - the Fed needs to accept additional financial accommodation. That said, Dudley's stance clearly opens the door to the possibility of the Fed running an excessively tight policy stance, which wouldn't happen if they took their inflation target seriously.

    Posted by on Thursday, March 12, 2015 at 11:54 AM in Economics, Fed Watch, International Finance, Monetary Policy | Permalink  Comments (32)


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