March 18, 2015 5:34 p.m. ET
The dollar is up, and the Federal Reserve has no place to go.
Fed policy makers on Wednesday dropped their promise that they can be “patient” on when to start raising short-term interest rates. That left open the possibility they might begin tightening policy at their June meeting—but they also made clear that is probably not in the cards.
That was a big surprise for investors, who were factoring in a greater probability the Fed would begin to increase rates from near-zero levels in June. The result: Stocks surged, Treasury yields slumped and the dollar tanked against the euro.
Underscoring the Fed’s changed stance were updated economic projections. These called for a year-end, federal-funds rate of just 0.625%. That was well below the median forecast of 1.125% offered last December. And the new projection points to just two quarter-point increases in the fed-funds rate this year, and implies a September start date.
Why the switch? One thing that changed since December is the dollar has gotten even stronger. That happened as central banks around the world have been rowing in the opposite direction of the Fed, unleashing a flood of monetary stimulus.
For the Fed, the dollar’s climb appears to have gone too far, too fast. On a trade-weighted basis, the dollar has risen 10% versus other major currencies since December.
That puts it 28% higher than it was three years ago—a huge move. It is only matched by gains for the currency in the late 1990s, during the Asian financial and Russian debt crises, and the early 1980s when the Fed pushed rates sharply higher and broke inflation.
Now, inflation is running below the 2% the Fed is aiming for. And the dollar’s rise, which is weighing against the prices of imported goods, makes it even more unlikely the Fed will hit its target anytime soon.
Fed projections now center on prices excluding food and energy prices—the so-called core—to be up 1.3% to 1.4% in the fourth quarter from a year earlier. That compares with an earlier projection of 1.5% to 1.8%.
Additionally, the dollar’s strength will make U.S.-based companies’ products less competitive both at home and abroad. That will act as a drag on the economy, effectively tightening financial conditions even without a Fed move on rates.
But the most worrisome aspect of the dollar’s strength is what it says about the rest of the world. Indeed, its gains may not reflect a brightening picture in the U.S., but worsening conditions in Europe, Japan, China and elsewhere. Those could drag on the outlook for U.S. growth and inflation beyond the strong dollar.
Moreover, dollar strength could make conditions elsewhere much worse. According to the Bank for International Settlements, dollar-denominated credit extended to nonbanks outside the U.S. reached $9 trillion in the second quarter last year, from $5.3 trillion at the end of 2007. The more the dollar rises, the harder those debts are to pay off—particularly for energy concerns and other commodity-producers coping with sharply lower prices.
If Fed Chairwoman Janet Yellen wanted to mitigate the dollar’s rise, she succeeded—for now—even as she injected an aura of patience while removing the word “patient.” Before the Fed thinks about raising rates, it will have to be sure the clouds gathering offshore aren’t about to develop into a storm.
Write to Justin Lahart at [email protected]
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