The most important economic riddle of 2016 might be whether recession-battered American consumers and companies are strong enough to withstand the cold winds blowing in from abroad. And the U.S. Federal Reserve finds itself in the unenviable position of being the forecaster for whom the stakes are very, very high.
Itching to normalize interest rates after nearly a decade of ultra-low borrowing costs, the Federal Reserve may have acted too soon in December when it raised benchmark interest rates, some economists say. Now, the debate may turn to whether the Fed has to reverse itself, or at the very least abandon tentative plans to raise rates four or five times this year.
“It’s human nature that they are reluctant to admit that their decision to raise rates in December was a mistake,” economist and hedge fund manager Gavyn Davies wrote recently. “But I suspect that something deeper is going on.”
The dollar was already strengthening mightily by the time the Fed raised rates for the first time since 2006 in December, and early 2016 has brought extended financial turbulence on the back of major slowdowns in emerging-market growth. Both factors are now weighing on growth in the United States. The only question remaining: Are they weighing enough to upset the Fed’s calculation?
In a globalized world, U.S. officials have to ask themselves whether the American economy can “decouple” from regions where growth is falling or turning negative.
The dollar has risen against the backdrop of weaker growth in the European Union, still a massive merchandise export market for the United States, with $448 billion in two-way trade in 2015, according to the U.S. Census Bureau. The absolute numbers are large for China as well. But in context, the figures are less impressive, since the U.S. economy is far less dependent on exports than other major countries are.
Also, U.S. employment growth is coming in industries driven mainly by domestic demand, not hunger for manufactured exports. In the latest employment report, sectors such as healthcare and retail led job growth. The U.S. Department of Labor's Bureau of Labor Statistics projects job gains of 2.3 million from 2014 to 2024 in healthcare alone.
But the dollar, which has appreciated about 25 percent on a trade-weighted basis since mid-2014, is already squeezing corporate profits, and could at the very least curb expected growth in the manufacturing sector.
According to FireApps, a Phoenix company that tracks the effects of currency swings in the United States and Europe, the number of companies reporting the strong dollar is depressing earnings has risen steadily since mid-2014.
“North American companies reported the euro as particularly impactful relative to other currencies,” Wolfgang Koester, CEO of FiREapps, wrote in a report. “However, it is clear that significant impacts came from a range of currencies.”
And the impacts hit a range of companies in the United States. Retail giant Wal-Mart reported this week the strong currency was weighing on the profitability of its international operations, and it’s not alone. Jetmaker Boeing, restaurant chain McDonald’s, technology companies like Apple and Microsoft, and pharmaceutical manufacturers Bristol-Myers Squibb and Pfizer have all felt the impact of the muscular U.S. dollar.
And why did the dollar lift off from its relatively stable position in 2014? A portion of the blame goes to the Federal Reserve, as board member Lael Brainard warned in October, when other Fed officials were laying the groundwork for raising interest rates in December, a long-overdue move in the view of some of them.
Brainard, a former international economic policy official in the Clinton and Obama administrations, pointed out anticipating a rate increase produced the very effects of a rate increase.
When markets sensed the Fed was close to moving rates higher, there was naturally a rush out of investments denominated in euros, yen and other currencies, and into dollar-based opportunities, and a rise in the dollar. Lower and even negative rates imposed by other central bank only fed the trend.
That, in turn, depresses the prices of imports and makes the sale of U.S. goods abroad that much harder.
“A feedback loop has transmitted market expectations of policy divergence between the United States and our major trade partners into financial tightening in the U.S. through exchange rate and financial market channels,” Brainard cautioned in October. “Thus, even as liftoff is coming into clearer view ahead, by some estimates the substantial financial tightening that has already taken place has been comparable in its effect to the equivalent of a couple of rate increases.”
Goldman Sachs calculates what it calls a “Financial Conditions Index” — a tool for measuring the impact of equity and bond market activity on the availability of credit in a manner that can be compared to the rate increases that are the Fed’s main tool.
The index suggests the dollar, rising since mid-2014, has delivered the equivalent of 250 basis points of tightening, or 10 times what the Fed did in August. That development is “a reason to expect U.S. growth to stay significantly weaker than it was in 2014,” chief U.S. economist Jan Hatzius wrote. “But barring further sizable deterioration, it is not a reason to expect a recession.”
Still, it was enough for Goldman to abandon its previous prediction that the Fed will raise rates at its March meeting.
Against the backdrop of the mighty dollar in a turbulent world, the United States also has the mighty consumer, a free-spending, optimistic creature who has come to the world’s rescue at times of crisis. When Asian economies had their own, homemade crisis, in the late 1990s, American purchases of their exports greased the way for recovery.
Strong consumers have to have jobs and rising incomes, and the signs are multiplying that they do. “Consumers are beginning to benefit from tailwinds that have been building for a couple of years,” said James Glassman, chief economist for commercial banking at JPMorgan Chase.
The U.S. Commerce Department reported Friday inflation hit 2.1 percent on an annual basis in December, suggesting stiff consumer spending is pushing prices up. That said, the measure isn’t foolproof. A separate indicator watched by the Fed still shows inflation well below its target of around 2 percent.
While painful to the oil patch concentrated in North Dakota, Texas and Louisiana, the collapse in energy prices has put $150 billion into the pockets of consumers, Glassman noted. The need to retire debt, and the gun-shy feeling once-free-spending Americans might be feeling after the worst recession since the Great Depression, have limited the effect of this windfall so far.
Eventually, though, consumers will move, Glassman predicted.
Payrolls have now grown by 200,000-250,000 per month for three years, giving American workers confidence if they lose one job, they can find another. And disposable income, after lagging the official end of the recession for years, is now rising steadily.
Even the most recent data is positive. Weekly reports that signal how many workers are seeking unemployment benefits have held steady or falling in the last six weeks, suggesting the global stock market routs that have so vexed investors don’t worry consumers in the United States nearly as much.
“The data signal no letup in labor market improvement,” said Jim O’Sullivan, chief U.S. economist for High-Frequency Economics.
None of these developments necessarily means the Fed will have to eat crow and reverse itself, or suddenly speed up previous plans for rate increases, argues Mark Zandi, chief economist with Moody’s Analytics. It has stepped back from higher rates when the dollar rose and financial markets did somersaults in 2015, he pointed out, and it has room within its own rhetoric to do the same again — and be patient.
“Investors will learn that the Fed means what it says, namely that it will take several years to normalize rates,” Zandi said.