Most of the world needs accommodative monetary policy. The U.S. increasingly doesn't.
That's a problem for central banks looking to maintain financial stability during a time in which disinflationary forces prevail in most parts of the globe, and it's a particular pain for the Federal Reserve, whose recent decision to stand pat on interest rates, combined with dovish rhetoric and a subdued outlook, placed it firmly back in position as the central bank for the world.
"One interpretation of the recent moves by the European Central Bank and the Federal Reserve is that they represent coordinated attempt to ease global financial conditions while avoiding upward pressure on the U.S. dollar, especially against the Chinese renminbi," write Chief Economist Jan Hatzius and Economist Sven Jari Stehn of Goldman Sachs Group Inc, giving a nod to the so-called Plaza Accord 2.0 theory.
In its statement last week, the Fed noted the resilience of the U.S. economy in the face of financial market turmoil stemming from the devaluation of China's currency in August by highlighting that that activity had been expanding at a moderate pace despite these headwinds.
But inasmuch as these widening spreads and a lofty greenback were drags that hampered U.S. activity, they won't be around too much longer, according to Goldman's economists. That's because the spate of central bank dovishness in recent weeks has substantially eased financial conditions across developed markets, a positive development for growth should these conditions persist.
Central bank coordination can only go so far, however, if the Federal Reserve remains committed to achieving its dual mandate of full employment and price stability (which monetary policymakers define as core PCE inflation running at an annual rate of 2 percent). And while Janet Yellen, who chairs the Fed, might not be convinced that core inflation is trending sustainably higher, Goldman Sachs certainly is:
"The upshot of this chart is that our seven core inflation measures have accelerated fairly steadily over the past six to nine months, with a core PCE-equivalent rate that has risen from around 1.25 percent in early 2015 to 1.75 percent now," they explain. "So core inflation is still below target, but the gap has shrunk significantly."
And while metrics on wage growth can be volatile and diverse, Hatzius and Stehn's analysis of all the data available leaves them much more optimistic than the Fed Chair that wages are picking up concurrently with prices amid a tightening labor market:
If Yellen's declaration that the Fed is not targeting an economic overshoot—that is, allowing the labor market and inflation to exceed their mandates—can be taken at face value, then the U.S. central bank will need to pursue a much more aggressive pace of tightening to facilitate this outcome, according to Goldman.
"To guard against significant overheating, we think that the FOMC would want output and employment growth to slow as we enter 2017," the economists write. "But this seems inconsistent with the current setting of financial conditions."
Put another way, if the blowout in spreads and strength of the dollar still haven't been enough to stop the U.S. unemployment rate from declining steadily—which implies that growth has been above the trend—that alone is enough evidence to suspect much more tightening is required to rein in activity to a level at which the economy won't be running too hot.
Goldman estimates that the Fed will need to carry out four rate hikes this year to strike this balancing act and avoid a more brisk removal of monetary accommodation later that could tip the economy into recession.
In other words, the strength of the domestic economy will soon force the Fed to return to being the central bank for the U.S., rather than for the world.
"If we are right, the Fed's willingness to keep policy easier for longer in the name of global policy coordination is likely to be short-lived and the funds rate will rise significantly further than currently discounted in the bond market," conclude Hatzius and Stehn.