Ben Bernanke just passed his first test as Federal Reserve Board chairman. On Feb. 15-16, he held his own during a Capitol Hill grilling by both houses of Congress. But that challenge pales in comparison with those that await him. The toughest will be shaping monetary policy in a global economy. Globalization makes it harder than ever to find the right level of interest rates to foster solid economic growth while keeping inflation at bay. That complication increases the chances the Fed could make a policy mistake by pushing rates too high or leaving them too low. Correcting the error could cost the economy dearly later on.
Globalization and its impact on monetary policy is not just about how worldwide competition suppresses prices of U.S. products. More and more, prices of everything from steel to corporate bonds to even labor are determined by market forces overseas, not just those in the U.S. Bernanke stressed the importance of flexibility in policy decisions, saying that policymakers must keep "an open mind about the many factors, including myriad global influences, at play" in the economy.
Against this global backdrop, measures of labor market tightness or constraints on output capacity traditionally used by the Fed to gauge wage and price pressures have become increasingly less reliable. That is, in a global economy, the inflation potential of, say, January's 4.7% jobless rate or last month's nearly 81% utilization rate for industrial capacity is much harder to interpret.
Moreover, an increasingly pervasive international capital market complicates the Fed's search for a neutral interest rate that neither stimulates nor restricts economic growth. Some economists even argue that, because of a lack of investment opportunities outside the U.S., the neutral rate might even be lower than the current policy stance. Bernanke himself has explored this view, but that interpretation would imply that the Fed already may have overtightened.
Right now, that seems unlikely. If anything, strong economic data for January, especially the powerful 2.3% rise in retail sales and a hefty 0.7% gain in manufacturing output, imply that rates may be too low.
THE GROWING SCOPE OF GLOBALIZATION is evident in the government's December report on international trade. The full-year tally for the volume of U.S. trade -- shown as the sum of foreign-made goods and services bought in the U.S. and American-made products purchased overseas -- stood at $3.3 trillion for all of 2005. That volume has doubled in only 10 years.
Heading into 2006, trade volume accelerated. Both exports and imports posted strong advances in December -- 2.1% and 1.9%, respectively -- and the growth rates of both sped up in the final three months of the year. During the past two years, the sum of U.S. exports and imports grew at an annual rate of 13.2%, the fastest two-year increase since 1988, when the dollar's plunge fueled an explosion of exports. Given the resilience of U.S. demand, the continued strength in China and emerging Asia, and the gathering momentum in Japan and the euro zone, trade volumes will swell further this year.
Clearly, one alarming symbol of the new globalization is the growing imbalance in world trade, illustrated by the ever-widening U.S. trade deficit. The gap for goods and services hit a record $725.8 billion in 2005, based on preliminary data. The gap has ballooned to 5.8% of GDP in only the past eight years.
THAT DRAMATIC WIDENING illustrates how economies are becoming increasingly dependent on one another for rising living standards. For example, China looks to foreign markets, especially in the U.S., to generate funds to develop its economy. Cheap imports boost the purchasing power of U.S. consumers, and emerging Asian nations benefit as China outsources some of its production of materials and parts. Most important, the U.S. and other nations get China's surplus savings to help finance their investment and growth.
One result is that the Fed has less control over the cost of capital, its primary tool in keeping the economy running smoothly. With the world outside the U.S. awash in excess savings looking for a place to be invested, heavy global demand for U.S. securities is at least one of the factors holding down long-term interest rates.
More broadly, overall financial conditions are no tighter now than when the Fed began lifting rates in June, 2004, despite the Fed's hikes in short-term rates, totaling 3 1/2 percentage points. Not only do long-term rates remain low enough to support both housing and corporate borrowing, but the credit markets see less risk in lending now than when the Fed first started tightening. That's implied by the interest rate spread between corporate bonds and riskless Treasury bonds, which is narrower now than it was then.
And banks continue to be aggressive in seeking out new borrowers. The Fed's January survey of bank senior loan officers shows that banks continue to ease the terms and conditions on commercial and industrial loans to businesses. Also, the survey indicated that banks are still not toughening up their lending standards on mortgage loans, despite reports of the Fed urging them to do so.
`RELATIVELY EASY FINANCIAL CONDITIONS are one factor stoking U.S. demand in early 2006. Consumers got off to an explosive start this year, taking advantage of January's balmy weather and the redemption of all those holiday gift cards. The 2.3% jump in retail sales from December to January was the largest monthly gain since October, 2001, when sales were boosted by generous incentives by carmakers right after September 11.
The data mean that consumer spending and overall economic growth are rebounding with gusto this quarter, after the fourth quarter's weak showing. In fact, the strong start suggests that the Fed's latest forecasts for growth and inflation in 2006 might be too low.
Those numbers also imply that a lot of that demand will be going abroad, placing additional pressure on the trade deficit and the need for foreign capital to finance it. Two other globalization issues might also create problems for the Bernanke Fed. One is the growing threat of protectionism. Congress seems likely to consider the bill by Senators Charles Schumer (D-N.Y.) and Lindsey Graham (R-N.C.) to impose a 27.5% tariff on all Chinese imports, perhaps within the next month or two. That would effectively raise import prices and nudge up overall inflation.
The other is the likelihood of a renewed decline in the dollar. The economic fortunes of both Japan and the euro zone are turning up. More Japanese and euro zone savings will be staying at home, even as both economies attract more foreign investment. That leaves fewer global funds going to U.S. assets, which would cause the dollar to weaken.
Given the new global interdependency across economies, a full-blown dollar crisis seems unlikely, but a renewed dollar decline would generate some additional inflation pressures in the U.S. via higher import prices, giving the Fed yet another global issue to work around.
By James C. Cooper