Since When Did the Fed Care So Much About the Global Economy?

The most interesting development from the most recent Fed meeting was its focus the on the global economy. Though in the past the Fed has focused mainly on the domestic economy when making policy decisions, they now appear to be equally focused on the global economy, particularly China, and the risk that weaknesses abroad pose to the U.S. economy. An entire sentence was added to the FOMC statement articulating this new focus: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” For context, adding an entire sentence to the statement is a big deal. 

How has the global volatility created concern about the U.S. economy? Two main reasons:

1. Global financial market volatility like falling Chinese stocks has tightened financial conditions in the U.S. through weaker equity prices and wider credit spreads. This can slow economic activity. These metrics are captured in the Bloomberg Financial Conditions Index.

2. A strengthening dollar depresses inflation via lower import prices. It also makes U.S. exports more costly abroad. Below is a chart of the trade-weighted dollar index, which measures the U.S. dollar versus the countries we have the most trading exposure to. 

The main takeaway is that improving labor market conditions aren’t enough to push the Fed to tighten policy. At 5.1%, the unemployment rate is close to the Fed’s long-term target for the natural rate of unemployment, but this isn’t the whole story. The interconnectedness of the global economy means investors need to watch not only what happens here, but how global developments could impact the U.S.

Sources: Bloomberg, RBS