Up to now, one of the few sure things financial markets could bet on was an inevitable rise in U.S. interest rates. The only question was when the U.S. Federal Reserve would hike rates – in the middle of 2015 or in the fall.
Economically, there’s a lot in favor of raising interest rates. Politically, however, there’s another question: Can the United States stand idly by as the dollar rises in reaction to the European Central Bank’s new bond buying stimulus?
Last week, the Fed again managed to create some legroom. After its monetary policy session, it emphasized that the U.S. economy was developing “solidly” and spoke of “strong” jobs growth. But at the same time, it said it would factor in “international developments” in any future interest rate decisions.
The Fed admitted that inflation for U.S. consumer spending sank to 0.8 percent in the short term, and would rise only “in the medium term” toward the inflation goal of 2 percent. Former Treasury Secretary Larry Summers warned that deflation was coming, fueling doubts of an imminent interest rate hike.
From an economic viewpoint, the prevailing argument has been that the Fed would act soon to raise interest rates, as it has announced in the past. For one thing, the U.S. economy is robust, with 2.4 percent growth in 2014. Germany and other euro zone countries were happy about that.
If the euro-dollar rate nears parity, pressure will grow for the Fed to keep its monetary policy expansive.
The U.S. economy created more jobs in 2014 – almost 3 million – than it did in any of the previous 15 years. In addition, low oil prices and sinking import prices due to the rising dollar should help boost consumer spending, by far the largest sector of economic performance.
Domestic oil and gas production, which has flourished recently in the United States, will suffer of course. But the industry employs only about 0.05 percent of the U.S. workforce. So on balance, weak oil prices will help more than they hurt.
Exchange rates, however, also have a big political and geostrategic impact. From that point of view, it’s hard to imagine that the Fed would sit still and allow loose monetary policies in the euro zone and Japan to cause weak growth and sinking inflation in the United States.
The euro zone is already showing a significant trade surplus with the United States, which should keep rising with the weak euro. And the more U.S. industry production slows, the more the exchange rate will become a big issue in Washington politics. If the euro-dollar rate nears parity, pressure will grow for the Fed to keep its monetary policy expansive.
Risks of rising inflation would not stand in the way. According to economic textbooks, moving toward full employment creates rising inflation through wage increases.
And yet this chain of effects – known as the “Phillips Curve” – has not been seen in the United States for 15 years. Whether that’s due to globalization or digitalization, or completely different causes, is open to debate.
Also, recent successes in the U.S. job market have obscured a big drop in those actually seeking work. Within the last 10 years, the portion of the workforce actively seeking jobs has declined from 66 percent to 63 percent. That means that less than 63 percent of Americans are still working or seeking work.
In a continuingly good economy, some of the millions of employees who gave up looking for jobs during the crisis should return to the job market, increasing competion and thus curbing the rise in wages. It is no surprise then that U.S. labor costs rose only about 0.6 percent in the fourth quarter of 2014.
So there is a lot in favor of the Fed pushing its planned interest rate hike back to 2016. Why should it accept a stronger and stronger dollar that carries negative consequences for the U.S. economy?
The global currency war, therefore, goes into the next round.
To contact the author: [email protected].