Dollar Gains Bolster Fed’s Patience on Interest Rates

New York Fed President William C. Dudley
William C. Dudley, president of the Federal Reserve Bank of New York. Photographer: Scott Eells/Bloomberg

The dollar’s strongest year since 2008 is a source of growing concern among some Federal Reserve policy makers, who say further gains have the potential to curb economic growth and keep inflation too low.

Atlanta Fed President Dennis Lockhart, New York’s William C. Dudley and Chicago’s Charles Evans have all said in the past week they are watching the dollar as officials debate the timing of the first interest-rate increase since 2006. A strong dollar tends to restrain exports by making them more expensive, holding back growth, while reducing the cost of imported goods.

“We’re going to take that into account, the way it’s affecting the economy in terms of net exports and GDP growth and what it means for our inflationary developments,” Evans told reporters yesterday after a speech in Chicago.

Evans and Dudley are among policy makers who argue that the Fed can afford to be patient on raising interest rates, and that tightening prematurely poses a greater risk to the world’s largest economy than waiting too long.

“They are worried about the durability of the labor-market recovery and inflation still running below their target, and the dollar feeds into that,” said Guy Berger, U.S. economist at RBS Securities Inc. in Stamford, Connecticut.

Prices as measured by the Fed’s preferred gauge, the personal consumption expenditures index, rose 1.5 percent in the year through August, compared with a 1.7 percent gain through May. Price gains haven’t exceeded the Fed’s 2 percent goal since March 2012.

Less Inflation

“If you have a stronger dollar you’re going to have less inflation, and that’s the reason they’re focusing on it,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York and a former New York Fed economist, who said the dollar’s gains so far are unlikely to affect monetary policy.

“If the dollar keeps going up obviously it may have implications for the timing of tightening,” he said.

On the other side of the debate are officials such as Dallas Fed President Richard Fisher, who favors an interest-rate increase at the end of the first quarter of next year. In a Bloomberg Radio interview yesterday, Fisher called the strength of the dollar “a vote of confidence” in the U.S. economy.

“Everybody is finding the things that are favorable to their side of the argument,” Berger said. “In the case of the doves, the dollar is one of them.”

Influenced by instability in Ukraine and divergent monetary policies in the U.S. and Europe, the dollar has risen 6 percent this year against a broad basket of currencies weighted by trade volume, the biggest increase for any year since 2008. Since July 1, the greenback is up 6.7 percent.

Spot Index

The Bloomberg Dollar Spot Index increased 0.2 percent to 1,070.94, the highest close since June 2010. It gained 6.7 percent this quarter, the most since the three months ended September 2008. The index measures the performance of the greenback against a basket of 10 leading global currencies.

“There’s no question a rise in the dollar, others things equal, weakens the domestic economy and lowers inflation,” said Chris Varvares, senior managing director and co-founder of St. Louis-based Macroeconomic Advisers LLC.

Investors bet that the dollar rally has further to run.

Data from the Commodity Futures Trading Commission in Washington show that net longs totaled 238,056 contracts last week, or about $35.1 billion, and approaching the record 311,052 contracts in June 2012. In July, positioning showed net bets against the dollar.

“If the dollar were to strengthen a lot it would have consequences for growth,” Dudley said in an interview last week with Bloomberg News Editor-in-Chief Matthew Winkler.

Trade Performance

“We would have poorer trade performance, less exports, more imports,” Dudley said. “And if the dollar were to appreciate a lot it would tend to dampen inflation. So it would make it harder to achieve our two objectives. So obviously we would take that into account.”

In addition to stable inflation, the Fed aims for full employment, which it defines as a jobless rate between 5.2 percent and 5.5 percent. Unemployment fell to 6.1 percent in August, matching the lowest since September 2008.

Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York, estimated that the 4 percent appreciation in the trade-weighted dollar over the past two months will reduce growth by 0.3 to 0.4 percentage point in the next year.

The economy expanded at a 4.6 percent annual pace in the second quarter. Net exports, the difference between exports and imports, reduced growth by 0.34 percentage point.

Fed officials predict they will raise their benchmark interest rate above zero some time next year, according to forecasts released on Sept. 17. The rate has been held near zero since December 2008.

Rate Timing

Slower growth would have consequences for the timing of an interest-rate increase, according to Macroeconomic Advisers.

The firm estimates the Fed will lift its benchmark rate to above 4 percent by the end of 2017, assuming no further gains by the dollar. If the dollar rises by 10 percent over the 12 months starting July 1 on a broad trade-weighted basis, that projection drops to below 3 percent.

The reasons for the dollar’s gains will make a difference for Fed policy makers, some economists say.

Political instability in places like Ukraine is driving investors toward the safety of U.S. assets, pushing up the dollar. The prospect of tighter monetary policy in the U.S. and further easing in the euro zone is contributing to the gains.

“Insofar as the dollar represents market attitudes about diverging central bank policies, the message to the Fed is, ‘Job well done’,” said Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York. “Why should you be pushing back against that?”

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