Constraints on the US Fed

There has been talk of the spillover effects of the actions of advanced country central banks, notably the US Fed, on other economies. This limits the freedom of action of those economies, especially emerging markets.

It is equally true, however, that conditions in the emerging markets impose constraints on the actions of advanced economies' central banks, as an article in the Economist points out:

IN THE weeks after December 17th, when the Federal Reserve raised its benchmark interest rate for the first time in nearly ten years, confident Fed officials told markets to expect four additional rate hikes in 2016. It has been obvious for a while that this guidance was wildly optimistic. Economists have been downgrading growth forecasts and markets have been retreating. At its meeting earlier this month the Fed acknowledged reality: it not only left rates unchanged, but also signalled in its projections that it expects to raise them by just two notches this year. This climbdown was not a surprise, but it does conceal a surprising admission: that American monetary policy is constrained, in part, by conditions in global financial markets.

The main reason is that in integrated financial markets, no economy can afford to be out of step with policies in the rest of the world nor can policy makers ignore conditions elsewhere. Policies cannot be framed only with respect to conditions in the domestic economy. Last December, it seemed natural for the Fed to hike the policy rate given that unemployment rate was down to 5% and inflation was edging up to the 2% mark. However, the Fed hike had immediate repercussions:

In late 2015 the expectation of a rate rise in America sent capital gushing into the country, pushing up the value of the dollar and tightening credit conditions elsewhere in the world. An expensive dollar makes American exports less competitive and places a drag on growth and inflation in the American economy. The effect on investors’ appetite for risk is more immediate.

Between the Fed’s December meeting and early February, American stocks dropped by 10%; share prices in Europe and Asia fell by more. The spread between corporate-bond yields and those on safe government debt rose sharply (see chart). Not until mid-February, as policymakers around the world sought to soothe markets with promises to support growth, did the panic dissipate. Since then, share prices have recovered and the dollar has fallen in value; with its decision on March 16th, the Fed confirmed investors’ suspicion that it would not continue on its planned tightening path.

It is interesting that in these conditions, the very definition of an inflation target is changing. When the US Fed talks of a 2% inflation rate as its target, it does not mean the inflation rate at a given point in time. It means the average inflation rate over a given period. So, if inflation was below 2% in recent years, it can afford to be above 2% in the coming years. This is what one calls ex-post justification- after the event, you find an argument to justify your position.