Stanley Fischer, vice chairman of the board of governors of the Federal Reserve System, did something unprecedented last week: he gave a speech. It wasn't just any speech.
Few Federal Reserve officials have ever made a speech like this. It was about the value of the dollar and U.S. monetary policy. Given how important central bank attention to the price of U.S. currency is, Fischer's comments should get more attention.
Former Fed Chairman Paul Volcker was right when he wrote in his book Changing Fortunes that "a nation's exchange rate is the single most important price in its economy." The exchange rate is particularly important for a country whose central bank is close to being the world's bank.
Fischer has a different opinion. He stated, "The exchange rate is a primary focus of central bankers in small open economies as well as a prime concern of the broader public in those economies." Many will recall that he is a former governor of the Bank of Israel. Of course, Israel is a "small open economy."
Fischer continued, "Given that the U. S. economy is much less open than Israel's, it is not surprising that fluctuations in the dollar typically receive somewhat less attention here in the United States."
He also added that "fluctuations in the dollar "also play a significant role in the U. S. economy, a role that has increased over time given growing global trade and financial linkages."
In advancing his argument, Fischer said that there "are two related factors that have played a role in the dollar's rise. First, there is the fact that the United States recovery is out-of-sync with the economic recoveries in "major foreign economies."
As a consequence, the central banks in these areas have been "providing additional monetary accommodation" causing foreign interest rates to decline relative to U.S. interest rates "encouraging investors to shift into dollar-denominated assets and in turn boosting the dollar," he said.
But, there is a second cause. There "has been a heightened concern about the global outlook and an associated decrease in investor risk tolerance-factors that tend to increase investment in dollar assets." The concern here is with China and other emerging market economies.
The rise in the value of the U. S. dollar has caused economic growth to slow and has resulted in lower inflation. And, these results have caused the Fed to engage in a "greater degree of monetary accommodation." That is, because of the impact of the increasing strength of the dollar, the Fed has not, as intended, raised its target for short-term interest rates.
But, Fischer concludes, the U.S. economy seems to be "weathering" the shocks of the past year "reasonably well" and so it seems that "it may be appropriate to raise the target range for the federal funds rate at the next meeting" of the FMOC "at the next meeting in December."
He ends with the usual caveat that "the outcome will depend on the Committee's assessment of the progress that has been made toward meeting our goals of maximum employment and price stability."
In other words, nothing has changed inside the Fed.
The Federal Reserve is solely focused upon what is going on inside the United States and the movement in the value of the U. S. dollar over the past year or so has been an inconvenience that Fed officials have had to deal with. But, Federal Reserve models show that modest economic growth will continue, unemployment will stay around 5.0 percent, and that the decline in inflation has just been temporary and actual inflation will return in the near future to the Fed's desired target of 2%.
Things cannot stay this way. The Federal Reserve is in a much more central position in world financial markets and cannot just focus on what is going on inside the United States.
Mario Draghi, president of the European Central Bank, has "dropped another hint that ECB is readying more measures to boost the eurozone's recovery." Draghi "is likely to unleash a more aggressive quantitative easing package and consider cutting interest rates next month."
How will the Federal Reserve react to these actions, given that it is, according to Fischer, focusing on U.S. unemployment and U.S. inflation?
"Persistent policy divergence will be hard to maintain given the interconnectedness," of international financial markets, said Allianz Chief Economic Advisor Mohamed El-Erian.
What El-Erian is saying is that the interconnectedness of the world's financial markets is so substantial that it is difficult, if not impossible, for one country to conduct its monetary policy independently of what else is going on in the world.
Fischer, unfortunately, in his speech, is not really giving us any confidence that officials at the Federal Reserve really comprehend this situation.