Why The Go-It-Alone Fed Can't Go Far With Rate Hikes

Washington (Nov 28)  Even before the Federal Reserve begins to raise its benchmark interest rate from historic lows, the US dollar is approaching its highest point in a dozen years.

The dollar's rapid ascent — 25% since early 2014 — is a measure of just how hard it will be for the Fed to lift rates to anything approaching previously normal levels. That's because it isn't due to robust growth in the U.S., but rather to foreign central banks taking more aggressive steps to combat weak economic conditions, in part by depressing the value of their currencies.

The European Central Bank is widely expected to announce expanded asset purchases at its Dec. 3 meeting, two weeks before the Fed meets on raising rates for the first time in nearly a decade.

For every step forward the U.S. economy takes, it's backsliding a half-step as the dollar puts domestic production at an increasing disadvantage. That dynamic was apparent in Tuesday's third-quarter GDP report reading on U.S. corporate profits, which fell 4.7% from a year earlier — the steepest dive in six years.

Likewise, core capital goods orders, such as machinery, were down 3.8% from a year ago in October, the Commerce Department reported Wednesday.

"Domestic demand for core capital goods is not strong, as manufacturing as a whole struggles with stagnation," IHS Global Insight economist Michael Montgomery wrote. "Foreign competition is stiff, thanks to the robust dollar, and export markets face reluctant customers who are more inclined to take advantage of cheaper prices available from our foreign competitors."

Emerging Market Pain

Fed policymakers have taken note of the dollar's rise and its associated challenges. It doesn't just mean slower growth in the U.S. It can also be a problem for emerging market companies with dollar-denominated debt, because debt levels can rise well beyond any boost in sales, thanks to competitiveness gains from a weaker local currency.

Another reason the dollar's rise may not be good for emerging markets: It doesn't only reflect diverging monetary policies, but also a lower risk appetite. The dollar's rise reflects "heightened concern about the global outlook and an associated decrease in investor risk tolerance — factors that tend to increase investment in dollar assets," Fed Vice Chairman Stanley Fischer said in a recent speech.

He noted investor concern over "the possibility of a sharp slowdown in China and other emerging market economies, with commodity exporters seen as particularly vulnerable in the wake of the dramatic drop in oil and nonoil commodity prices since the summer of 2014."

Source: IBDinvestors