The Fed ignores external developments at its peril

One has to wonder whether the Federal Reserve is paying sufficient attention to external developments in gauging the likely course for U.S. inflation. There appears to be a growing chorus of Fed officials intimating that the Fed will start raising interest rates by the middle of 2015, if not sooner. And they do so at a time when there are at least two major external developments that would suggest that the U.S. could see a marked deceleration in headline consumer price inflation over the next few months. Indeed, it is not difficult to envisage that those external developments could cause consumer price inflation to decelerate toward zero by the end of 2015, which could raise anew fears of U.S deflation.

The first external development is the recent collapse in international oil prices. Over the past six months, oil prices have fallen by 35 percent from around $100 a barrel to $65 a barrel. A rule of thumb commonly used in gauging the impact of oil price movements on the U.S. economy is that a sustained $10 a barrel decline in oil prices boosts U.S. gross domestic product (GDP) by 0.2 percentage points while it shaves 0.4 percentage points off U.S. consumer price inflation. On that basis, one would presume that if the recent $35 a barrel decline in oil prices is sustained, U.S. consumer inflation in 2015 would be around 1.4 percentage points lower than it would otherwise have been.

{mosads}Considering the present state of global oversupply of energy and of Saudi Arabia’s reluctance to play its past role as swing energy producer, it would not seem unreasonable to expect that international oil prices will remain at their present low levels for an extended period of time. Indeed, one could envisage a situation where international oil prices might decline even further, especially if the global economic recovery were to continue losing steam.

The second major external development that could drag U.S. inflation lower is global exchange rate movements. Since the launch of Abenomics in Japan at the beginning of 2013, the Japanese yen has depreciated by around 40 percent against the dollar. It did so as the Bank of Japan (BOJ) embarked on a highly aggressive round of quantitative easing to end Japan’s many years of deflation. Judging by the BOJ’s recent decision to ramp up its quantitative easing program further to a level that in relative terms far exceeds the Fed’s past actions in this field, one could see the Japanese yen continuing to depreciate in 2015.

Judging by Europe’s poor economic performance and by its slow drift toward outright deflation, it has to be only a matter of time before the European Central Bank (ECB) begins buying sovereign bonds. The ECB has already announced that it intends to expand its balance sheet by 1 trillion euros over the next two years. In anticipation of such action, the euro has already depreciated by more than 10 percent against the U.S. dollar, to its lowest level in the past two years. Judging by past experience, one must expect a further significant weakening in the euro once the ECB actually begins its sovereign bond-buying program to meet its balance sheet expansion objective.

The depreciation of the Japanese yen and the euro has already resulted in a significant relative strengthening in the U.S. dollar that is bound to have a meaningful impact on the U.S. economic outlook. Indeed, over the past year, the U.S. dollar has now appreciated by more than 10 percent in nominal effective terms. Moreover, there is every prospect that it will appreciate further in the year to come, considering that the U.S. economy appears to be strengthening at the same time that the Japanese and European economies continue to struggle.

In gauging the impact of dollar movements on the U.S. economy, a rule of thumb that is often used is that a 10 percent appreciation of the U.S. dollar can shave 0.5 percentage points off GDP growth and at the same time reduce inflation by 0.5 percent. For this reason, it is not difficult to envisage that any further appreciation of the U.S. dollar, coupled with continued weakness in international oil prices, could very well cause U.S. headline inflation to decline toward zero by end-2015.

In normal times, the Fed is justified in making its policy decisions without too much regard to external developments. However, as underlined by the recent sharp decline in international oil prices and the very sharp decline in the Japanese yen, these are far from normal times. In gauging the likely course of the U.S. economy and of inflation over the next year, the Fed would be ignoring those external developments at its peril.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.