Missing the point!

Gavyn Davies has written a disturbing piece in the FT: The Fed and the dollar shock:

The dismal performance of asset prices continued last week, despite a rebound on Friday. There are many different forces at work, but recently the focus has turned to the weakening US economy. This weakness seems to be in direct conflict with the continued determination of the Federal Reserve to tighten monetary policy.

Janet Yellen’s important testimony to Congress on Wednesday acknowledged downside risks from foreign shocks, but overall her attitude was deemed by investors to be complacent about US growth. (See Tim Duy’s excellent analysis of her remarks here.)

Why is the Federal Reserve apparently reluctant to respond to the mounting recessionary and deflationary risks faced by the US? It is human nature that they are reluctant to admit that their decision to raise rates in December was a mistake. Furthermore, they believe that markets are often volatile, and the squall could yet blow over.

But I suspect that something deeper is going on. The FOMC may be underestimating the need to offset the major dollar shock that is currently hitting the economy.

The broad dollar effective exchange rate has risen by about 20 per cent since mid-2014, the greatest dollar shock in recent decades. Because the US is a relatively closed economy, with exports accounting for only 13 per cent of GDP, the FOMC often pays little more than lip service to foreign trade shocks. Yet, this one is large enough to disturb the underlying growth rate of the entire economy. Unless the recent dollar strength substantially reverseswhich probably(!) requires the Fed to take rate rises off the table for a whileUS economic growth could continue to disappoint.

The point being missed is that the “dollar shock” is a reflection of the “NGDP growth shock”. And the” NGDP growth shock” follows on the “tightening talk” that began in earnest in mid-2014!

Gavyn Davies appeals to the well-known Goldman Sachs Financial Conditions Indicator (FCI), with the chart reproduced below.


And writes:

The increase in the dollar has been by far themain cause of the tightening in US financial conditions in the past two years. This tightening in the FCI has been repeatedly mentioned by the Fed leadership, including Janet Yellen and William Dudley, who introduced an index to measure financial conditions when he was Chief US Economist at Goldman Sachs in the 1990s. But they are not yet ready to do much about it.

The GSFCI is still the most prominent indicator used by investors to assess the effects of financial conditions on GDP growth. The index suggests that there has been a tightening of about 250 basis points in the FCI since the dollar rise started in mid-2014. This is surely a much greater tightening in monetary conditions than was intended by the Fed, which has consistently talked about a very gradual removal of monetary accommodation over the next several years.

The above discussion reminded me of Scott Sumner´s post from yesterday:

The markets don’t know exactly where the central bank has set their put, so prices plunge lower and lower until they see signs from the central bank that it will boost NGDP growth. What looks like a stock crash causing an NGDP slowdown, is actually a stock market predicting that central bank passivity will fail to stop an NGDP slowdown. Markets also know that central banks prefer fed funds targeting to QE and negative IOR. And they know that central banks are “only human” and don’t like to admit mistakes by suddenly reversing course. That’s what caused the recession in 1937, and if there is one this year (still far from certain) that stubbornness will again be the cause.

NGDP growth appears to be a ‘sufficient statistics’ for the ‘stance of monetary policy’. Note that the multivariable Goldman Sachs FCI is basically a reflection of that monetary policy tightening!


Although the Fed still says that rate rises will be gradual, and the Vice-Chair Stan Fischer recently said that four rate hikes during 2016 “sounded right”, the markets think that there will be no rate increases in 2016. That´s not enough to halt the slide, because markets know “that central banks are “only human” and don’t like to admit mistakes by suddenly reversing course”, so it´s as far as they (the markets) will go!

The root of all-evil: The strong dollar

Reasoning from a price change (RFPC) is one of the most common mistakes made by economists, journalists and pundits.

This take from “Why the Fed won’t raise rates in October” — in five charts” is illustrative:

One of the factors weighing on inflation is the strong U.S. dollar, which is up about 14 percent over the past year against a broad basket of other currencies. A stronger dollar makes American exports less competitive in the global marketplace, and Goldman Sachs estimated that is dragging down U.S. growth by a full percentage point right now.

So it lowers growth and inflation! That should give people the hint that it´s a negative demand shock, coming from? You guessed: tight monetary policy!

How come? Interest rates remain “on the floor”. But a few (including Bernanke) know that´s a very bad indicator of the stance of monetary policy. Better if you take a look at what´s happening to NGDP growth.

Not surprisingly, it´s falling


Bringing down inflation


Strengthening the dollar


And pushing down commodity and oil prices


PS. RFPC is , at least, “consistent”: “How Global Easing Makes the Fed’s Job Harder”:

For the Fed, that is worrisome. Further dollar strength could cut into inflation more and weigh on growth. If(!) the Fed tightens while all other central banks are loosening, the dollar could strengthen even more, intensifying the problem.

The global squall that kept the Fed on hold in September is looking more and more like a storm that is gathering pace.