Yellen Losing Dollar Bet as Its Rise Slows Growth, Inflation

Janet Yellen Testifies Before The House Financial Services Committee

Federal Reserve Chair Janet Yellen.

Photographer: Andrew Harrer/Bloomberg
  • Fed to delay next rate move in response, JPMorgan says
  • Strong dollar has big economic impact in Fed computer model

Federal Reserve Chair Janet Yellen and her colleagues have so far found themselves wrong-footed by the stronger dollar after they raised interest rates last month for the first time since 2006.

In spite of suggestions by some officials that the U.S. currency’s rise would soon run out of steam, the dollar has appreciated by some 2 percent since the central bank last met on Dec. 16, measured on an effective exchange rate-basis. Coming on top of a 11 percent increase in the year prior, the latest advance will curb already slowing economic growth and put downward pressure on an inflation rate that the Fed judges is too low as it is.

“It’s a big move in a month,” said Robert Mellman, a senior U.S. economist at JPMorgan Chase & Co. in New York, adding that was a key reason why the bank recently pushed back its forecast of the Fed’s next rate rise to June from March. “The cumulative effects of a stronger dollar on the economy and inflation are substantial.”

On Hold

Yellen and her fellow officials are almost universally expected to hold rates steady at their first gathering of the year on Tuesday and Wednesday. Investors though will be scouring the statement released afterward for hints that the Fed is backing away from its base case of four quarter percentage-point rate increases in 2016.

The U.S. central bank said Monday that the meeting will go ahead in spite of a severe winter storm that has disrupted travel to and from Washington. Policy makers from outside the city unable to attend in person will be take part via video conference.

This year’s bout of turbulence on world financial markets -- the dollar and Treasury debt prices have surged while equity and commodity prices have plunged -- has prompted investors to scale back their expectations of Fed action. They now see at most only two rate hikes this year and put the odds of March move at 26 percent. That’s down from 46 percent this time last month, according to trading in the federal funds futures market.

‘Developments Abroad’

When the Fed last confronted unsettled financial markets and an uncertain global economic outlook in September, it postponed an expected rate increase and said it was "monitoring developments abroad." After markets calmed down, policy makers boosted rates in December, with Yellen extolling the strength of the domestic economy in comments to reporters after the decision.

Morgan Stanley & Co. economists in New York expect the Fed to again give a nod to international and market concerns in their statement this week, but without closing the door to a March rate increase.

Yellen will not be holding a press conference after this week’s meeting. She will though get a chance to more fully explain the Fed’s thinking when she appears before the House Financial Services Committee on Feb. 10 to deliver the central bank’s semi-annual report to Congress.

In a speech on Nov. 12, Fed Vice Chairman Stanley Fischer said computer calculations by the central bank show that a 10 percent rise of the dollar lowers U.S. gross domestic product by more than 1.5 percent after three years, mainly by reducing exports.

Slower Growth

GDP is projected to have grown by just an annualized 0.8 percent in the fourth quarter, according to the median forecast of economists polled by Bloomberg. The government is scheduled to release the numbers on Jan. 29.

A dollar rise also temporarily reduces inflation by lowering the price of imports, Fischer said. Fed calculations suggest that a 10 percent appreciation depresses core inflation by about 0.3 percent over a year. Core inflation, which excludes volatile food and energy costs, stood at 1.3 percent in November from the prior year, well below the Fed’s 2 percent goal.

In separate comments earlier this month, St. Louis Fed President James Bullard and San Francisco Fed President John Williams both suggested that they did not anticipate a major increase in the greenback in the future.

"I wouldn’t expect a lot of appreciation in the dollar going forward, because markets have already priced in what is going to happen with relative monetary policy" in the U.S. and Europe, Bullard said in Memphis, Tennessee, on Jan. 14.

Emerging Markets

The currency’s latest rise though has come not so much against the euro, but against the currencies of commodity exporters such as Canada and Asian nations that are suffering the fallout from slower Chinese demand, JPMorgan’s Mellman said. 

Movements in the U.S. currency are the most important thing to watch in determining the pace of Fed rate rises in 2016, according to Michael Salm, co-head of fixed-income at Putnam Investments LLC in Boston.

"When the dollar rises, it slows things down, it’s a form of tightening on its own," he said. "The single, most-important macro global indicator this year is the dollar."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE