The dollar is no longer an excuse for the Fed not to raise rates

The strong dollar is no longer an excuse not to raise rates.

Shortly before the Federal Reserve raised interest rates in December, Fed governor Lael Brainard gave a speech about why it should proceed cautiously.

Brainard’s reasons included the strong dollar, which had seen a 15% rally over the previous year and a half. This argument noted that the strong dollar was putting downward pressure on the neutral rate — or the interest rate at which inflation would accelerate — requiring the Fed to keep its official Fed Funds rate low.

In an afternoon note Friday, Renaissance Macro’s Neil Dutta points out that the dollar has been falling even though expectations for higher interest rates have been going up. In other words: this fear that the dollar would put the Fed in a bind and keep rates lower.

Here’s Dutta (emphasis ours):

Remember that story about how if the Fed hikes, the dollar strengthens, EM crumbles, which drives the US dollar even higher, further keeping the Fed from hiking because of exchange rate pass through to inflation. Looks like that negative feedback loop is breaking down. Someone tell Brainard.

This chart shows how the dollar’s rally versus expectations for higher rates:

Brainard’s argument about how the strong dollar moves the neutral rate matters because the rate is a benchmark for evaluating whether monetary policy is accommodative or not.

It is gauged as the level at which the Fed Funds rate — which the FOMC will decide on again next week — is in line with the economy reaching full employment and an optimal level of inflation.

Measures like the Wu-Xia model for interests show how the neutral rate was negative for years after the recession.

And while the thinking was that a strong dollar would keep this rate lower, Dutta’s argument is the action we’re seeing in markets right now — dollar down, stocks up, bond yields up, expectations for Fed action getting pulled forward — is arguing the other side of that.

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