The Fed shift to a more tolerant stance on inflation will be a drag on the Buck for years and will raise hard questions about the role of central banking, challenging policymakers from Frankfurt to Tokyo.
The Fed’s policy ‘tweak‘, unveiled on 27 August appears tailored to giving the US economy a shot in the arm. A shift to average inflation targeting lets the Fed overshoot its target after downturns, indicating that rate hikes will come later and the jobs market will be allowed to run hotter, a boon to low-income families.
But this creates 2 difficula issues for global central banks.
Such a reinterpretation of the Fed’s mandate could be seen as a foray into social policy, a vital precedent for others as they reexamine their own roles after years of unconventional moves that already impact wealth and income distribution.
The 2nd concern will be the USD’s weakness, which hurts exporters from Europe to Asia. This is bound to feature prominently at the European Central Bank’s policy meeting Thursday, as a strong Euro will make it more difficult for exporting nations in the Eurozone to climb out of their deepest recession in living memory.
Countries like Germany and France, or Japan, traditionally generate growth from net exports, which take a hit when their currencies firm. And this firming compounds their problem as trade wars between the United States and some of its Key trade partners are already weighing on exports.
USD has already weakened by over 10% Vs a basket of currencies since mid-March to a more than 2-yr low, prompting ECB chief economist Philip Lane to warn last week that the exchange rate mattered, even if the ECB did not target it.
“If there are forces moving the euro/dollar rate around, that feeds into our global and European forecasts and our monetary policy setting,” Mr. Lane said.
Some economists say that the current exchange rate could already deduct 0.2%-0.4% from Eurozone growth and analysts see more USD weakness.
Normally this would not be too difficult to counter but the ECB and the Bank of Japan are both close to the limits of ultra-easy policy.
Both have cut rates into negative territory and yields are already negative for much of the curve. Both banks also face some domestic opposition to more easing, making further moves politically complicated.
As long as Fed policy makes it harder for USD to rise, the BoJ will have to worry about potential JPY rises that needs a policy response including a deepening of negative interest rates.
Some economists argue that the ECB should simply shift to a similarly flexible target as part of its own ongoing policy review. But markets is pricing no rate hike at all during Christine Lagarde’s 8-yr term atop the bank, so a suggestion that policy tightening would be even further pushed out raises credibility issues.
The Fed’s aim to help low-income families is another complication as it elevates the role of the bank in social policy and could be seen as a sort of reinterpretation of its mandate. The shift will be benign.
Lower USD rates will cut funding costs in emerging markets, accelerating growth and providing a bigger market for exports. And letting US inflation run higher now, will raise both long term rates and inflation expectations, making it easier to normalize policy after years of extraordinary accommodation.
These may prove true, but that will not be evident for years to come. So, until then, central banks must deal with a weaker USD.
Have a healthy week, Keep the Faith!