Fed's Rate Decisions Hang On Dollar, Growth Concerns

By Jon Hilsenrath 

        The strong U.S. dollar and an unsteady global economy are emerging as primary concerns for Federal Reserve officials as they prepare for a policy meeting next week to consider the timing of the first interest-rate increase since before the financial crisis.
        The Fed already has said it's unlikely to raise rates next week and officials in recent interviews and public comments have signaled a rate increase in June has become less likely because the economy slowed in the first quarter.
        As they discuss the outlook beyond midyear, officials are increasingly weighing how much the strong dollar might have hurt the prospects of achieving their economic forecast of annual growth of around 2.5%, gradual increases in inflation and continued declines in unemployment.
        Fed officials have said they won't raise rates until they're confident inflation is on track to rise toward their 2% target, and they want to see the job market keep improving. A stronger currency tends to undermine exports because it makes them more expensive. That slows growth and potentially hiring. Meantime, the strong currency holds down the prices of imports and broader inflation.
        The dollar's strength and uneven global economic growth have become an increasingly important part of the Fed's outlook, said Eric Rosengren, president of the Federal Reserve Bank of Boston, in an interview with The Wall Street Journal on Monday.
        "We are at very different points in the world economy," he said, noting that the U.S. and to some degree the U.K. are experiencing much stronger economic growth than Japan and Europe. "That means we are going to be in an environment where exchange rates and interest rates may be more volatile than if everybody was moving more synchronously. We do have to be concerned."
        New York Fed President William Dudley, part of Fed Chairwoman Janet Yellen's inner circle, placed the currency at the top of his list of worries in a speech Monday.
        "While I am relatively optimistic about the growth outlook for 2015, I also must acknowledge that there are some significant downside risks," he said. "In particular, the roughly 15% appreciation of the exchange value of the dollar since mid-2014 is making U.S. exports more expensive and imports more competitive."
        New York Fed economists estimate the dollar's appreciation could reduce the growth rate of U.S. economic output by about 0.6 percentage point this year.
        Fed officials hold their next policy meeting April 28-29. On Tuesday they began their routine self-imposed "quiet period" in which they refrain from making public comments and enter into premeeting discussions.
        The Fed's increasingly open discussion of the dollar outlook is unusual. The central bank tends to minimize its comments on the currency to leave discussions of foreign-exchange policy to the U.S. Treasury.
        In this case, Fed officials are trying to stay focused on the exchange rate's effects on the economic outlook. Yet it becomes impossible to disentangle that from the Fed's own interest-rate policies, which in turn influence the dollar.
        The dollar's appreciation since July outpaced its spurts during the technology-stock boom of the late 1990s, when the U.S. economy was charging ahead and emerging-market economies in Asia and Russia were plagued by financial crisis. It has stabilized since the Fed's March meeting, when officials reduced their interest-rate forecasts for the coming three years. But Fed officials believe the effects of its climb are still washing through the economy.
        Since January, economists surveyed by the Journal have reduced their projections for how fast the economy will grow this year from 3% to 2.7%, thanks in part to the effects of the dollar move. They have also reduced their estimates of the change in the consumer-price index inflation gauge from 1.6% to 1.3%. Other factors are shifting the outlook. The collapse of oil prices has led to a reduction in oil and gas drilling. That is hurting investment the near term, but lower gas prices could boost consumer spending later.
        As growth expectations diminish, so are market expectations for a Fed move. The central bank has held its benchmark short-term interest rate near zero since late 2008. Since March, investors in futures contracts linked to the rate have signaled they see diminishing odds of a rate increase even by September.
        The Fed's dollar dilemma points to a broader challenge faced by the U.S. central bank: Its own communication about the outlook for interest rates--meant in part to prevent market uncertainty and avoid financial instability--may have made it harder to achieve its economic goals.
        Fed officials have been signaling since last year that they expected to raise rates in 2015 because they forecast the economy would continue strengthening. Investors anticipating that move have plowed funds into U.S. dollar assets in search of higher returns, pushing up the value of the currency and contributing to the economic slowdown officials now confront.
        The challenge is in some ways reminiscent of the bond market's 2013 "taper tantrum" that preceded the Fed's gradual end of the bond-buying program known as "quantitative easing."
        In that case, U.S. interest rates began rising in May in anticipation of the move and dented a fragile housing recovery. The Fed ended up delaying by a few months its announcement of an end of the bond program.
        In this case, Fed communication is rippling through currency markets rather than bond markets, but the net effect is a similar drag on the economy.
        The Goldman Sachs Financial Conditions Index--which tracks the broad effects of interest rates, stocks, currency and other factors on the availability of money--reached a level of financial restraint in mid-March that it hadn't reached since the taper tantrum of 2013.
        "The market followed Fed statements that became progressively less dovish over the course of last year," said Roberto Perli, an analyst at Cornerstone Macro, a research firm. By March of this year, "the market became prepared for a June liftoff."
        Mr. Perli noted that the Fed has no easy way out of this dilemma. If it avoids giving guidance, it risks stirring even more market instability when it actually acts.
        Fed officials tend to agree.
        "The appropriate response is to be clear about what we're trying to achieve," Mr. Rosengren said. "There are going to be market reactions whenever you're shifting from an economy that has had very low interest rates for a long period of time to an economy that has more normalized interest rates. While that is a positive story overall, there is the possibility that will be a bumpy ride."
        Still, Mr. Dudley said the Fed must gauge the market's response to its actions as it decides what to do next.
        "If financial conditions tighten unduly, then this will likely prompt us to [raise rates] much more slowly or even to pause for a while," he said.
        Write to Jon Hilsenrath at jon.hilsenrath@wsj.com
        (END) Dow Jones Newswires

        April 22, 2015 05:30 ET (09:30 GMT)

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