Why the Fed wor­ries about oth­ers

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

AS ex­pected, Wed­nes­day's re­lease of the last Fed­eral Re­serve min­utes has af­fected the fi­nan­cial mar­kets. Most com­men­tary has fo­cused on the cen­tral bank's con­tin­ued support for risk as­sets -- an im­por­tant contributor to the stock mar­ket's im­pres­sive re­cov­ery this week. But another as­pect also war­rants at­ten­tion: the ex­tent to which Fed of­fi­cials are mon­i­tor­ing and wor­ry­ing about what's go­ing on out­side the U.S.

His­tor­i­cally, and away from the oc­ca­sional crises in Europe and the emerg­ing world, Fed min­utes have de­voted lit­tle space to ex­ter­nal de­vel­op­ments. There have been two good rea­sons for this.

First, the U.S. is a "closed econ­omy" -- that is, eco­nomic growth, jobs and in­fla­tion are over­whelm­ingly de­ter­mined by what goes on inside the coun­try rather than any­where else in the world. Sec­ond, the U.S. has tra­di­tion­ally been a "price maker" rather than a "price taker" on global fi­nan­cial mar­kets -- its in­flu­ence on in­ter­na­tional fi­nan­cial mar­kets far ex­ceeds any spill-back from them.

In ad­di­tion to spend­ing rel­a­tively lit­tle time on de­vel­op­ments else­where, Fed of­fi­cials have dis­played an aver­sion to talk­ing pub­licly about the neg­a­tive ef­fects of U.S. mon­e­tary pol­icy. This ap­plies in par­tic­u­lar to emerg­ing coun­tries that find it tricky to nav­i­gate a global sys­tem in which the is­suer of the re­serve cur­rency (the U.S. dol­lar) has been ex­per­i­ment­ing with un­con­ven­tional mon­e­tary poli­cies for a pro­longed time.

While main­tain­ing its re­luc­tance to dis­cuss this pol­icy spillover, the Fed seems more open now to talk­ing about the do­mes­tic sen­si­tiv­ity to for­eign eco­nomic and fi­nan­cial de­vel­op­ments, and un­der­stand­ably so. For­eign mar­kets are now more im­por­tant to the U.S. not just in the tra­di­tional way. Also, the prices of what con­ven­tion­ally have been re­garded as highly do­mes­tic U.S. se­cu­ri­ties are now more durably in­flu­enced by de­vel­op­ments abroad.

The weight of ex­ports in U.S. gross do­mes­tic prod­uct is now about 14 per­cent, an ex­pan­sion of almost 50 per­cent in the last 10 years. With the share of im­ports also ris­ing (to 17 per­cent of GDP), trade is more im­por­tant, and it isn't just Nafta-driven. Among the top five U.S. trad­ing part­ners, coun­tries that aren't part of the North Amer­i­can Free Trade Agree­ment now re­ceive almost twice as many U.S. ex­ports as Nafta mem­bers do.

Ex­ter­nal fi­nan­cial de­vel­op­ments can also have a siz­able im­pact on U.S. as­set prices. This goes beyond the head­lines that vis­i­bly move U.S. eq­ui­ties -- Rus­sia-re­lated geopo­lit­i­cal ten­sions, for ex­am­ple, Chi­nese growth statis­tics or ac­tion by the Euro­pean Cen­tral Bank and the Bank of Ja­pan. The de­vel­op­ments also in­volve de facto lim­its on how far U.S. as­sets can de­cou­ple from "sim­i­lar" as­sets in the rest of the world. Just wit­ness what's been hap­pen­ing to the 10-year U.S. Trea­sury bond, an in­flu­en­tial bench­mark for the do­mes­tic econ­omy and fi­nance. One might have ex­pected yields to go up in re­cent months, as the U.S. econ­omy re­cov­ers and the Fed grad­u­ally eases its foot on the mon­e­tary­pol­icy ac­cel­er­a­tor. In­stead the yields have been sharply pulled down by plum­met­ing Ger­man yields as­so­ci­ated with the euro zone's growth weak­ness, de­fla­tion­ary trends and prospects for re­newed ECB as­set pur­chases.

In­deed, the gap be­tween the coun­try's two yields has had dif­fi­culty -- at least so far -- de­ci­sively break­ing above 150 ba­sis points. In­stead, it has been the for­eign-ex­change mar­ket that has been the main shock ab­sorber for the pro­nounced di­ver­gence in eco­nomic per­for­mance and mon­e­tary poli­cies, push­ing the euro sig­nif­i­cantly weaker against the dol­lar.

Given all this, it is un­der­stand­able that the Fed is pay­ing more at­ten­tion to what's go­ing on else­where. Specif­i­cally, in the Fed­eral Open Mar­ket Com­mit­tee min­utes re­leased on Wed­nes­day, "many [FOMC] par­tic­i­pants re­garded the in­ter­na­tional sit­u­a­tion as an im­por­tant source of down­side risks to do­mes­tic real ac­tiv­ity and em­ploy­ment." More­over, the Fed pol­icy mak­ers no­ticed that move­ments in as­set prices "ap­peared to have been im­por­tantly in­flu­enced by con­cerns about prospects for for­eign eco­nomic growth and the as­so­ci­ated ex­pec­ta­tions in mon­e­tary pol­icy ac­tions in Europe and Ja­pan." All of which brings up some­thing I have men­tioned be­fore. If left to its own de­vices, the U.S. econ­omy would con­tinue to gain mo­men­tum, with a broad­en­ing and more in­clu­sive re­cov­ery help­ing to strengthen the un­der­ly­ing do­mes­tic fun­da­men­tals. This in turn would help val­i­date the lev­els of as­set prices and fa­cil­i­tate an or­derly nor­mal­iza­tion of mon­e­tary pol­icy.

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