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Strong Dollar Not Keeping (Most) Fed Members Up at Night

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April 6, 2015

It’s clear there’s some nervous murmuring over the strong U.S. dollar—which is trading at its highest levels in over a decade—up and down the halls of the U.S. Federal Reserve. Policy meeting minutes note the buck’s strength, and central bankers have confirmed in speeches that wide currency gaps are on their watchlists of economic warning signals.

But other than a largely cursory nod to a strong greenback, dollar trading likely holds little sway over the actual near-term course of Fed interest rate action. Such was the argument of a new paper issued by the Cleveland Fed branch in mid-March, in which researchers called fears that a beefy buck will tip U.S inflation into negative territory “certainly overblown.”

At the root of these opinions is the Fed’s concern (plus Wall Street jitters—see figure 1) that a strong U.S. currency could drag the U.S. economy into disinflation, or worse and much harder to reverse, deflation, where a total lack of pricing power grips the economy. The risk is that a sharply higher dollar could force the U.S. to “import” downward price pressure.

Now, it's also true that the Fed will keep tabs on the sting to exports (specifically export-dependent companies) that comes with a richer dollar. The net trade drag has to be included in the Fed's economic checklist, especially in an environment of weak global demand.

Chart of SPX and the dollar

FIGURE 1: INTER-MARKET ANALYSIS. SPX (pink line) charged to record highs over the past year even as the dollar (candlesticks) gained, but early-2015 stock nerves were pinned partly on a strong dollar’s impact on earnings and Fed uncertainty. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results. 

At the Periphery

It’s just one more complication for a Fed that is hoping to gently wean the U.S. economy and Wall Street off accommodative interest rate policy by raising rates, to be determined at an upcoming meeting (most forecasts peg June or September). The Fed needs some inflation traction to put that policy change in motion. In fact, the dollar has been driven higher on prospects the Fed will lift rates while other economic powerhouses are keeping rates ultra-loose or have put other aggressive stimulus measures in place.

So, should the Fed care about these rate differentials and the resulting push-pull on currencies?

A couple of Cleveland Fed economists believe the buck’s backlash will be transitory at worst. They’re quick to point out that supply-driven weaker oil prices, and not exchange rates, have capped U.S. import prices.

But is that assessment a little wiggly? Yes.

“Dollar appreciations can have both direct and secondary impacts on import prices; consequently their effects can linger. However, they also suggest the effects are not sufficiently strong to affect the course of Fed thinking on monetary policy,” said Owen Humpage, economic adviser, and Timothy Stehulak, research analyst at the Cleveland Fed, in a report.

“Our rough calculations, which are consistent with previous findings, suggest that, in general, a jump in dollar exchange rates can affect import prices for at least six months, but that the overall impact is fairly small,” they said.

Limited Carry-Through

Through all the wonky stuff, there are some important discoveries for investors who wonder what makes the Fed tick. Noting the multi-year lows for crude prices, the Cleveland researchers focused on non-petroleum imports. They found that a 1% gain in the dollar’s exchange rate lowers non-petroleum import prices by 0.3% cumulatively over six months (figure 2). From its low in early July through the end of December 2014, the dollar appreciated 9% against a basket of currencies. But the drop in non-petroleum import prices tracked at a much tamer 1.3%.

U.S. import prices over six months in 2014

FIGURE 2: MINIMAL CHANGE. Cleveland Fed economists track the impact on U.S. import prices over six months in 2014, showing a minimal change even as foreign exchange fluctuations were much more pronounced. (Bars measure the percentage point changes in the non-petroleum import-price index over the contemporaneous and five subsequent months to a one-percentage point change in the broad dollar index.) Source: Cleveland Federal Reserve, based on authors’ estimations on data from the Board of Governors of the Federal Reserve System and the Bureau of Labor Statistics. For illustrative purposes only.

More importantly, the economists found only a small impact on consumer prices. While still tame, these didn’t fall substantially.

Just how transitory will the dollar impact be? The answer is likely to have a major bearing on how quickly the Fed does move, once it gets this train in motion. Fed Chair Janet Yellen, noted policy dove, has said she wants to be confident inflation is heading toward the Fed’s roughly 2% annual inflation target before she can get behind rate hikes.

In February, the latest month for data, widely reported core consumer prices (stripping out volatile food and energy) are up 1.6% for the past year. That’s largely because that roof over your head costs more. Another measure of inflation and largely known to be the Fed's favorite, the personal consumption expenditure (PCE) deflator, is running at about 1.3%, still below that 2% inflation target. So, will the Fed talk currencies, sure. Will the dollar dominate the Fed’s deliberations? Far from it.