The release of the March 15-16 FOMC minutes was generally seen as in line with the previous FOMC statement and recent speech by Yellen. The conclusion is Fed policy action is influenced by global uncertainty, and that warrants caution when raising interest rates. There were three excerpts in the minutes, however, that may pose a dilemma for the Fed's current cautious stance. These sections spoke to the following:
The Fed has little room to ease rates, but could raise them quickly in case of an overheating economy.
Weak foreign economic conditions, a persistently high exchange value of the dollar, and tighter financial conditions will continue to restrain (U.S.) economic growth for a time and thus collectively imply a temporarily low level for the neutral rate of interest.
Central bank limit:
Financial market turbulence provided an important reminder that the ability of central banks to offset the effects of adverse economic shocks might be limited, particularly by the low level of policy interest rates in most advanced economies.
The three issues suggest the Federal Reserve's dual mandate has a "third mandate" — namely, a global mandate. The global mandate consists out of global financial stability, global financial conditions and the global calendar of major economic releases. Although the dual mandate is said to be data-dependent, the Fed's global mandate is more calendar-based.
In 2012-2014, calendar guidance by the Fed was explicit. Today, forward guidance reentered the Fed's reaction function by way of global economic releases. If global uncertainty persists, the Fed's newly forward guidance by watching global economic events, may result in the "dot plot" to converge fully to market expectations. Those market expectations see Fed Funds currently below 1 percent by the end of 2018.
There is, however, another problem posed by the three listed issues. If the Fed were to proactively manage its dual mandate, it may come at the expense of its global mandate. If the Fed experiences "asymmetry ability" by having to raise rates quicker as the U.S. economy now at full employment experiences a period of inflation overshooting, global financial conditions would tighten too quickly through the strength of the dollar. This would adversely transmit through the global financial system by way of deeper negative rates in Europe and Japan, and distress in dollar denominated debt held in emerging markets.
On the other hand, if the Fed manages the global mandate at the expense of the dual mandate, U.S. interest rates are likely to fall more. This may spur capital flows from the U.S. to seek alternative higher-yielding assets globally. Although at first this capital flight may spark a "risk on rally", eventually global financial instability risks could reemerge as capital drives up global asset prices too quickly.
Managing a global mandate could also mean broader weakness of the dollar by way of lower U.S. interest rates. The consequence of a weaker dollar is likely higher commodity prices, which may drive U.S. and developed market inflation up quicker. Another effect from a weaker dollar is the strength of currencies such as euro and yen which creates a perception of failure of ECB and BoJ policy. Lastly, a weaker dollar that helps stabilize the Chinese yuan, may see a further increase Chinese FX dollar reserves. Such reserves are reinvested in liquid government bond markets, making it potent to lower global interest rates, compounded by Fed policy keeping U.S. rates lower.
The dilemma the Fed faces is to how balance the dual mandate with a global mandate. The Fed can't go too fast raising rates or that could result in global turmoil. The Fed can't go too slow either or financial instability risks increase. What the Fed is left with is to provide an "automatic stabilizer" to global financial markets by way of lower long term interest rates. This will keep the returns on Treasuries and Sharpe Ratios high by balancing Fed policy against global risk factors, and in the process face potential inflation overshooting because of a weaker dollar. The Fed's dilemma is global and the end result is global interest rates may post new record lows despite inflation may be rising.
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