“An odd thing is happening in the U.S. economy: consumers appear to be losing their taste for imported goods...From 2011 through the first quarter of 2014, imports of consumer goods have grown at less than half the rate of corresponding measures of domestic spending.” The possible implications of this are complex and interesting: “The U.S. tendency to import more than it exports [creates] vast trade imbalances, which [motivate] big exporters such as China to build up large central-bank reserves in their efforts to maintain favorable exchange rates. Those reserves [are] invested largely in U.S. Treasuries and other dollar-denominated securities...with less capital flowing into Treasuries from foreign central banks, interest rates could rise more quickly than the Fed expects.” Quick tangent: there’s another interesting phenomenon happening in the United States economy worth mentioning here: costs for services (education, child care and health care) are soaring while costs for goods (electronics, household, retail) are plummeting. Meanwhile, Mohamed A. El-Erian argues that exchange-rate movements in the “G-3 currencies” (dollar, euro and yen) are undermining policy makers’ efforts to achieve a robust and lasting recovery. Furthermore, “by making European and Japanese exports more expensive abroad and by reducing the relative prices of imports, they have a damping effect on growth and inflation in two parts of the world that need more of both.” Also, here is a quick rundown of what analysts are saying about the surprisingly weak $US this year: “something else in the market, a mystery flow, which we think of as Dark Matter. Our prime candidate for this is China’s reserve accumulation;” “the dollar bull case was about better growth and the prospect of monetary policy tightening in the future. But if the forward-looking investors have reduced capacity to be involved in long U.S. dollar trades, perhaps we need to get closer to the actual tightening before the U.S. dollar can actually take off.” Meanwhile, Financial Times has a thesis on rates (alt): “the strong performance of long-term bonds, up more than 11 per cent this year, has been buoyed by pension funds and insurers increasing their allocation to the sector. It has also been fanned by investors cutting their bearish bets against long-term bonds.” Furthermore, “a supportive factor for US long-term bonds is that their yields sit well above those of Germany and other countries...and the effect new regulation is having on bank liquidity further support a low yield environment.” Also, someone else at the Financial Times sees US and European bond yields falling even further thanks to 1) market expectations for higher rates actually end up having the opposite “desired” effect, and 2) “five years into the ‘recovery’ the output gaps (difference between expected and real) have not closed.” That being said, “the plain truth is that European bonds are priced for perfection. It follows that anything short of a perfect backdrop -- including a fumble-free Federal Reserve as it tries to unwind quantitative easing -- is likely to prompt a bout of buyers’ regret among investors who’ve chased yields in Europe to record lows.” Finally, here are the three most important questions to answer regarding Fed policy according to Larry Summers: 1) How much slack remains in the U.S. economy?, 2) Once the economy returns to normal, say 5.5% unemployment, where should the Fed expect short-term interest rates to be?, and 3) What else should the Fed take into account? I would like to propose a fourth question: Ignoring your answer to all of these questions, what do you believe the Fed’s answer to these questions would be?
