The Fed meeting this week was perhaps one of the most anticipated since the end of the Great Recession of 2008 as many expected the Fed to lift rates for the first time in nearly a decade.
However, the FOMC decided to keep the Fed Funds target rate unchanged at 0 – 25 basis points, repeating that they want to be ‘reasonably confident’ on inflation. The financial markets immediately reacted by selling the U.S. Dollar and pushing U.S. yields lower, while stocks got a bit of a relief rally.
The Federal Reserve’s mandate has always been to focus on the domestic economy for full employment and tamed inflation. Today the U.S. labor market is close to full employment and consumer spending has been strong. Monetary policy should be forward-looking to trim any inflation buds, so typically the Fed would raise rates back to at least normal levels.
So why didn’t the Fed raise rates?
First, this is a different economic cycle. While labor markets are tight, real wages still remain low and workers’ incomes have not come back to the levels prior to 2008. Unusually cheap commodity prices also take away from inflation pressures, and the Fed’s preferred inflation index of the Personal Consumption Expenditures (PCE) is only at 0.3%, still quite a bit lower than the 2% target.
But the other reason is that today, the Fed cannot ignore troubling global factors. The Fed has no mandate to take into consideration exchange rates (the USD value) or other countries’ fundamentals. However, the current strong USD (which has gone up by close to 20% in 12 months) is not only suppressing U.S. inflation but is starting to hurt our manufacturers. More importantly, the recent weakness in the emerging market (EM) economies seems to make the Fed more sensitive. These EM countries were once the driving forces of the global economic future but their currencies have fallen rapidly in the past 12 months in anticipation of a Fed rate hike this year – about 10% to 30%. China then devalued its currency to align with these currencies prompting the notorious stock market tumble last month. Whether the Fed raised rates by 25 basis points or not would not vastly impact the domestic U.S. economy. However, if this would create a chain reaction on the global economy, then the Fed had less incentive to act.
My View: This week’s Fed’s decision is about the global economy more than the U.S. economy. Since the rest of the world is still fragile, I believe the next possible Fed move in 2015 (Oct or Dec) will also be linked to the global economy. It also means that one country alone today cannot survive on its own so it’s important to maintain a healthy balance with other nations.
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