Via the WSJ:
DJ For Fed, Dollar’s Strength Complicates Rate-Hike Calculus
By Josh Zumbrun
Many Federal Reserve officials entered 2015 thinking they likely would start raising short-term interest rates by midyear. That idea got put on ice after a winter economic slowdown, partly attributed to the dollar’s rapid rise in previous months.
While the dollar’s value is down a bit from its March peak, the Fed’s own models show the greenback’s drag on the economy is likely to grow in coming months.
This and other factors could prompt some Fed officials to lower their latest growth forecasts, to be released at the next Fed policy meeting June 16-17–and to wait even longer to move on rates.
Many investors now expect the central bank to start lifting its benchmark short-term interest rate from zero in September. Fed officials say they won’t act until they see more labor-market improvement and are confident that inflation will rise toward their 2% goal.
For a window on how the dollar figures into the Fed’s thinking, meet “Ferbus.” That’s the nickname of the central bank’s economic model FRB/US, which crunches hundreds of mathematical formulas to estimate how the economy will perform.
Program the model with an upside or downside shock to the economy, such as government spending cuts or an increase in productivity, and the model will spit out the expected impact on everything from output and unemployment to interest rates and stock prices. Ferbus’s technical details are posted on the Fed’s website, allowing anyone to see the assumptions it makes.
Fed officials rely heavily, but not exclusively, on Ferbus’s calculations, which suggest the dollar’s hit to the economy is just being felt.
The dollar climbed by about 13% against a basket of other currencies over the six months ended March 31. Some of the effects appeared quickly. In March, the U.S. trade deficit rose to $51 billion, its widest gap since 2008, as U.S. exports became more expensive and imports became cheaper. The economy contracted by a 0.7% annual rate in the first quarter, nicked in large part by a 14% decline in exports, the biggest drop in six years.
According to Ferbus, a 10% increase in the exchange rate ripples through the economy gradually. In the first quarter after the shock, growth is shaved by a negligible 0.08% and the inflation rate by 0.1 percentage point. But the impact grows steadily for three years, as producers, exporters, importers and consumers adjust their habits. After two years, about 0.75% will have been lopped off GDP.
Fed officials “think it’s a drag on demand,” said Roberto Perli, a former Fed economist who is now a partner at economic-research firm Cornerstone Macro. “It’s more expensive to buy U.S. products, cheaper for U.S. people to buy foreign products. That’s by far the first order effect.”
Less expensive imports also can push down U.S. inflation, though researchers disagree about how much. Ferbus estimates the stronger dollar would bring the annual inflation rate 0.4 percentage point lower. Inflation has run below the Fed’s 2% target for nearly three years; a further decline would mean an even larger miss.
Ferbus doesn’t see the stronger dollar as all bad. Lower inflation raises consumer purchasing power. This doesn’t offset the hit to exports, but it makes consumers feel somewhat richer, and maybe more willing to spend.
One product that’s already cheaper is oil. The decline in crude prices over the past year is too large to be attributed just to the dollar’s strength–increased U.S. oil production and slowing global demand are also key factors. Ferbus shows a decline in oil prices should boost economic growth, helping offset the dollar’s strength.
Another benefit of the stronger U.S. dollar is its flip side–a weaker euro and yen, which helps boost the beleaguered economies of the European Union and Japan. That should help the global economy, and the U.S., according to the Fed’s thinking.
At their March meeting, Fed officials lowered their expectations for U.S. growth to a range of 2.3% to 2.7% this year and next. In December they had estimated a pace as high as 3% for both years.
Fed Chairwoman Janet Yellen attributed some of the March downgrade to the dollar’s strength. “Export growth has weakened. Probably the strong dollar is one reason for that,” Ms. Yellen said at her March news conference.
More recently, in a May 22 speech, Ms. Yellen said she still sees the U.S. as well positioned for growth. The economy’s weakness in the first months of this year, she said, may have been the “result of a variety of transitory factors.”
She cited the poor winter weather and labor disputes at West Coast ports as significant factors. The warmer spring and the resolution of those disputes could cause a rebound. If her assessment proves correct, she said, it could be “appropriate at some point this year” to begin raising interest rates.
However, if the economy disappoints–because of the dollar or other reasons–she and her colleagues might want to wait even beyond September before liftoff.
Write to Josh Zumbrun at Josh.Zumbrun@wsj.com