The Federal Reserve’s interest-rate-setting committee just wrapped up their meeting and as predicted, announced that they’ll hold rates steady. Markets were interested in any guidance on when the central bank would start slowly unwinding its balance sheet, to which the Fed’s statement said, “relatively soon.” So, not a lot to see here folks…move along.
Yet in the background, there’s been an interesting development in recent weeks, one that weighs on current monetary policy. Consider these two facts. First, the Fed has been consistently missing their inflation target to the downside. Second, following a “Trump bump” after the surprise election outcome, the value of the dollar has come down about 7 percent this year (the dollar fell after the Fed statement today, which currency traders presumably viewed as dovish).
These two facts point in different directions. Since a weaker dollar makes imports more expensive, it tends to correlate with higher prices. Its impact is dampened to an extent by the fact that our import share of GDP—15%–is relatively low (it’s twice that share in the UK). And of course, many other inflation determinants are in play in these days.
That said, a simple model of price growth that includes an index of the dollar against our trading partners does an OK job of tracking year-over-year changes in core PCE inflation (the Fed’s favored gauge). The figure below shows what happens when I let the dollar keep declining at its recent pace. Inflation picks up and by the end of this year, hits the Fed’s 2% target, then hits 2.2% by the end of 2018.
Suppose President Trump got confused and appointed Jared Bernstein to chair the Fed instead of Jared Kushner, and I let unemployment fall to 3.5% by the end of 2019. Inflation grows faster still, but not at anything like scary magnitudes. True, this is a toy model but given the flatness of the Phillips Curve right now (i.e., the low correlation between unemployment and inflation), I suspect at least some of the more structural models would generate a similar result.
Faster price growth would be a good thing (here’s Bin Appelbaum on why), but there’s a wrinkle to this dollar scenario: if the Fed continues on its rate-hiking, “normalization campaign,” we may not achieve that result. The reason is that higher interest rates raise the value of the dollar in international markets.
Of course, if the Fed were truly concerned about hitting, or better yet, exceeding its inflation target, which is supposed to be an average, not a ceiling, they wouldn’t be raising in the first place. Apparently, the drive to “normalize” rates is stronger than the drive to boost prices, which Chair Yellen thinks is going to happen on its own, just around the next corner.
But by continuing to raise, and thereby adding some strength to the dollar, they’re kinda working at cross purposes, at least as far as regaining some control over price growth.