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Why the Fed Worries About Others

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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As expected, Wednesday’s release of the last Federal Reserve minutes has affected the financial markets. Most commentary has focused on the central bank’s continued support for risk assets -- an important contributor to the stock market’s impressive recovery this week. But another aspect also warrants attention: the extent to which Fed officials are monitoring and worrying about what’s going on outside the U.S.

Historically, and away from the occasional crises in Europe and the emerging world, Fed minutes have devoted little space to external developments. There have been two good reasons for this. 

First, the U.S. is a “closed economy” -- that is, economic growth, jobs and inflation are overwhelmingly determined by what goes on inside the country rather than anywhere else in the world. Second, the U.S. has traditionally been a “price maker” rather than a “price taker” on global financial markets -- its influence on international financial markets far exceeds any spill-back from them.

In addition to spending relatively little time on developments elsewhere, Fed officials have displayed an aversion to talking publicly about the negative effects of U.S. monetary policy. This applies in particular to emerging countries that find it tricky to navigate a global system in which the issuer of the reserve currency (the U.S. dollar) has been experimenting with unconventional monetary policies for a prolonged time. 

While maintaining its reluctance to discuss this policy spillover, the Fed seems more open now to talking about the domestic sensitivity to foreign economic and financial developments, and understandably so. Foreign markets are now more important to the U.S. not just in the traditional way.  Also, the prices of what conventionally have been regarded as highly domestic U.S. securities are now more durably influenced by developments abroad. 

The weight of exports in U.S. gross domestic product is now about 14 percent, an expansion of almost 50 percent in the last 10 years. With the share of imports also rising (to 17 percent of GDP), trade is more important, and it isn't just Nafta-driven. Among the top five U.S. trading partners, countries that aren't part of the North American Free Trade Agreement now receive almost twice as many U.S.  exports as Nafta members do. 

External financial developments can also have a sizable impact on U.S. asset prices. This goes beyond the headlines that visibly move U.S. equities -- Russia-related geopolitical tensions, for example, Chinese growth statistics or action by the European Central Bank and the Bank of Japan. The developments also involve de facto limits on how far U.S. assets can decouple from “similar” assets in the rest of the world.

Just witness what’s been happening to the 10-year U.S. Treasury bond, an influential benchmark for the domestic economy and finance. One might have expected yields to go up in recent months, as the U.S. economy recovers and the Fed gradually eases its foot on the monetary-policy accelerator. Instead the yields have been sharply pulled down by plummeting German yields associated with the euro zone's growth weakness, deflationary trends and prospects for renewed ECB asset purchases. 

Indeed, the gap between the country’s two yields has had difficulty -- at least so far -- decisively breaking above 150 basis points. Instead, it has been the foreign-exchange market that has been the main shock absorber for the pronounced divergence in economic performance and monetary policies, pushing the euro significantly weaker against the dollar.

Given all this, it is understandable that the Fed is paying more attention to what’s going on elsewhere. Specifically, in the Federal Open Market Committee minutes released on Wednesday, “many [FOMC] participants regarded the international situation as an important source of downside risks to domestic real activity and employment.” Moreover, the Fed policy makers noticed that movements in asset prices "appeared to have been importantly influenced by concerns about prospects for foreign economic growth and the associated expectations in monetary policy actions in Europe and Japan.”

All of which brings up something I have mentioned before. If left to its own devices, the U.S. economy would continue to gain momentum, with a broadening and more inclusive recovery helping to strengthen the underlying domestic fundamentals. This in turn would help validate the levels of asset prices and facilitate an orderly normalization of monetary policy. 

But the U.S. isn't an isolated economic and financial island. The multiyear American war to overcome the terrible legacy of the global financial crisis now involves a consequential battle against weakness in the rest of the world. And the growing divergence between its domestic prospects and those of the rest of the world has become one of the most important uncertainties facing the global economy and markets in 2015.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Katy Roberts at kroberts29@bloomberg.net