The path of U.S. monetary policy may be shaped as much by what happens in Frankfurt and Tokyo over the next seven days as it is in Washington.
With the European Central Bank meeting today and the Bank of Japan on March 15, Federal Reserve Chair Janet Yellen and her colleagues will be closely watching what their foreign counterparts do — and how the currency and other financial markets react — in mapping out interest-rate increases for the U.S.
"If the ECB does more easing — as we expect them to do — then the Fed will worry mainly about what that does to the dollar," said Torsten Slok, chief international economist at Deutsche Bank AG in New York.
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Investors are betting that the Fed will hold interest rates steady at its March 15-16 meeting as it assess the impact of a shaky global economy and jittery financial markets. A rise in the dollar triggered by easier policy from the ECB and perhaps the BOJ would support a go-slow strategy to raising rates in the U.S.
Asked how the U.S. central bank would respond if the ECB pushed rates further into negative territory, Fed Governor Lael Brainard told CNBC television on March 7 that she was focused on developments in the U.S. She quickly added though that the economy was being buffeted by "powerful cross currents" from abroad and that a further rise in the dollar would hit manufacturing-industry exports.
Dollar's Impact
Policy makers "are all pretty on board about the dollar having a pretty big effect on the inflation numbers and on growth," said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.
He expects the Fed to leave open the possibility that it could increase rates in June without clearly signaling it will do so in the statement issued after next week's meeting, or at Yellen's subsequent press conference.
The ECB is widely anticipated to loosen policy at its March 10 meeting after President Mario Draghi flagged the likelihood of action this month. After disappointing investors with the stimulus he unveiled in December, setting off a rise in the euro, Draghi will be loath to do the same again, according to Roberto Perli, a former Fed official who's now a partner at Cornerstone Macro LLC in Washington.
Divided Opinion
Opinion is more divided on what the BOJ will do at its March 15 meeting after its adoption of negative interest rates in January backfired, sending the value of the yen higher and prices of Japanese bank stocks lower.
If the yen strengthens in response to easier policy from the ECB, the BOJ also might loosen its stance, though it will probably be cautious about lowering rates further, said Joachim Fels, global economic adviser for Pacific Investment Management Co.
Fed Vice Chairman Stanley Fischer alluded to the central bank's dollar dilemma when he spoke to the American Economic Association's annual meeting in San Francisco on Jan. 3.
While policy makers in general recognize the benefits of floating currency rates in redistributing demand throughout the world economy, "they're not so happy" when they're the ones "giving up some growth, for instance, by having their exchange rate appreciate," he said.
With the U.S. economy growing under 2 percent in the fourth quarter compared to the prior year, Fed officials probably are wary of having too much demand leak abroad through a widening of the trade deficit brought on by a stronger U.S. currency.
After rising nine percent in 2015, the dollar has gyrated in 2016, climbing early in the year when it looked like Fed policy makers might press ahead with a rate increase this month, then falling back as expectations of a move lessened. It's now little changed on the year against a broad basket of currencies.
"It's a strange dance," said Joseph Gagnon, a former Fed official now at the Peterson Institute for International Economics in Washington. "When they move in the direction of higher rates, the dollar goes up and that delays them from doing something."
The U.S. economy has so far been able to take the hit from a stronger dollar and weaker growth overseas without tumbling into a recession. The labor market, in particular, has been a standout, with payrolls increasing by more than 1.4 million jobs in the past six months.
"The U.S. recovery is looking fairly solid," Slok said.
Feroli noted that the dollar has eased a notch in recent weeks even as Fed rate expectations among investors have "crept a little bit higher." That could give the central bank an opening to lift interest rates in June, he said.
Unless, of course, the greenback reverses course and shoots higher in response to moves in the coming days from the ECB and BOJ. "The Fed still wants to keep raising rates," Fels said. "The question is will the markets allow them to do it."
Bloomberg News
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