Outside of crisis periods — and we aren't in one — the U.S. Federal Reserve normally behaves and speaks as if the U.S. is essentially a closed economy. Not so at its last policy meeting. The minutes released this week contain an unusual focus on both the world economy and the value of the dollar; and the drivers are a mix of old and new — at least they should be.
Commenting on economic developments and prospects, Fed officials pointed with concern to the slowdown in China, Europe and Japan. They also worried that the concurrent strengthening of the dollar would add to the risk of price deflation.
The Fed usually worries about foreign developments only if it thinks they pose a major risk of financial disruption; and officials are also wary about currency talk, especially since it falls in the domain of the Treasury Department.
Fed officials are likely concerned that economic weakness beyond American borders will weaken the nation's export performance and hold back growth, a phenomenon that could be easily compounded by rising geopolitical tensions. While exports don't represent a large part of the economy, the absence of a robust recovery means the U.S. can ill afford additional headwinds. And the broad appreciation of the dollar serves to erode competitiveness of American products.
Having said this, I doubt that these traditional reasons sufficiently explain the Fed’s unusual focus on international issues. I suspect the Fed is also being driven by two other considerations.
First, global economic weakness would undermine the ability of the Fed to maintain financial asset prices well above the levels strictly warranted by the fundamentals. This threatens both the real and perceived effectiveness of its policies, given that this is the major channel through which the Fed, acting largely on its own, is trying to engineer an economic recovery.
Second, if trends in the currency markets continue, including what is already a 7 percent appreciation of the dollar versus the euro in less than four months, it is only a matter of time until this foreign-exchange volatility affects other financial markets. Such a generalized spike in volatility would pose a second threat to the effectiveness of the central bank's policies.
The question isn't whether the Fed should worry about what happens overseas. It should. It is whether it can work with policy makers from other countries to achieve a better collective outcome. This weekend’s policy discussions in Washington will be a good opportunity for such an endeavor. But I fear this opportunity won't be fully exploited.
As such, we should expect global references in Fed minutes to become more regular — and, for some time, to offer little (if any) comfort.
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