GBP/USD: Bifocal Policies

GBP-USD, Bifocal Policies, Federal Reserve, Open Market Committee, Fundamental Analysis, fx trader, forex

15 Jan 2016

On 16 December, the US Federal Reserve’s Open Market Committee announced that the current pace of economic expansion no longer warranted a 0.00% to 0.25% Fed Funds target. It was decided to implement the first of several planned gradual increments of the Fed Funds target. The decision was welcome by some, criticized by others. The Phillips Curve1 has long been a key metric weighing on the scale of the Fed’s Open Market Committee decisions. In a nutshell economist William Phillips demonstrated an inverse relationship between unemployment and wage inflation: As unemployment declines, wage growth quickens and vice versa.  However, this doesn’t seem to be the case as demonstrated by actually comparing consumer prices with the declining rate of US unemployment2 in recent years.

GBP-USD, Bifocal Policies, Federal Reserve, Open Market Committee, Fundamental Analysis, fx trader, forex GBP-USD-graphicsData from St. Louis Fed

Former Treasury Secretary and Economist Lawrence Summers noted in a Washington Post blog3 that “...Inflation is running well below 2 percent and there is not yet much evidence of acceleration. Decades of experience teaches that the Phillips curve can shift dramatically so reasoning from the unemployment rate to inflation is problematic. Declining prices of oil and other commodities suggest inflation expectations may actually decline. Furthermore, if one believes that productivity is understated by official statistics one has to as a matter of logic believe that inflation is overstated... ...It seems to me looking at a year when the stock market has gone down a bit, credit spreads have widened substantially, and the dollar has been very strong, it is hard to say that now is the time to fire a shot across the bow of financial euphoria...

There’s an interesting philosophy here. In his blog, Mr. Summers views the decline in energy and commodity prices in an integral factor; the logic being that if energy and non-energy imports are declining, that should weigh on maintaining policy. The Fed sees it a different way4, “...Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports...”  The Fed tends to ‘single out’ energy5 and has often referred to the commodity price factor as ‘transitory’.

This raises some important questions. If most advanced economies are still in an easing cycle, several with benchmark rates in a neighborhood of zero, then it follows that a rate increase strengthens the dollar. If so, in light of other advanced economy’s rate policies, wouldn’t this then make energy (and non-energy) imports less expensive in terms of US Dollars? Hence, isn’t it then reasonable to conclude that non-core US CPI will continue to decline while core CPI remains unchanged? Hence the Fed may be too focused on a too narrow measure of consumer prices.

In the same statement, the Fed also noted that “... net exports have been soft...” So again, if currencies in US export markets are weakening, and the US Dollar has strengthen by way of the benchmark rate increase, wouldn’t the combined effect ‘amplify’ pricing of US goods and services in the export destination markets?