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The Federal Reserve can turn the leaf - gently

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A strong dollar is a powerful dampener of U.S. inflation. Over the last twelve months, the dollar's trade-weighted exchange rate rose 13.3 percent – marking 14.4 percent and 13 percent increases against the euro and the yen, respectively. These two currencies are legal tenders in one-fifth of the world economy, which is a destination for 18 percent of America's foreign trade.

How important is all that in the Federal Reserve's policy deliberations? There are two parts to the answer.

First, the dollar's exchange rate operates directly on U.S. exports and imports, which represent nearly one-third of the economy.

Second, that impact is much wider. Acting as a de facto import subsidy, the rising dollar puts downward cost pressures on American import-competing industries. At the moment, these pressures are quite strong. Driven by the weakening energy market, the U.S. import prices declined 5.5 percent last year, showing the largest drop since 2008. Nonfuel import prices were also falling toward the end of 2014, but remained stable for the year as a whole.

Facing strong foreign competition, domestic producers are forced to seek productivity gains in order to keep the costs down and protect their market shares at home and abroad. U.S. nonagricultural producers, for example, were able to cut their export prices last year a record 2.9 percent.

A broader impact of foreign-trade-induced price effects can also be seen in the U.S. consumer price index. Thanks partly to sectors exposed to rigors of world clearing prices, our consumer price inflation in December was down to 0.8 percent. However, price inflation in sheltered sectors like medical care services, restaurants, utilities and energy services ranged from 2.4 percent to 5.8 percent.

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U.S. wages have also been affected. As shown by falling export prices, there is no doubt that competitive pressures of a strengthening dollar held down hourly compensations in the nonfarm business sector to 2.5 percent in the first nine months of last year, despite a vigorous labor demand that created 1.7 million new jobs in 2014.

So far, these exchange rate effects have not had a noticeably negative impact on net exports. It is estimated, for example, that the U.S. trade balance on goods and services has not been a drag on economic growth in 2014. But that is likely to change this year.

A continuation of European economic stagnation and weaker growth in East Asia are bound to cause a significant shrinkage of U.S. export markets in these areas. A strong dollar will only compound that negative demand effect to drive up the trade deficit and increase downward pressures on American economic growth.

A dollar shortage

These examples show that in a highly open economy exchange rate effects are important signals for monetary policy. That is particularly the case for the U.S., whose currency serves as the word's key reserve asset and a dominant transactions medium in global trade and finance.

At times, exchange rate movements can also create policy dilemmas. We are facing one of them right now, because the dollar's rising relative price indicates its shortage in world financial markets. If the Fed wanted to follow that signal and stop the dollar's climb, it should stand ready to supply additional dollar liquidity to create a better demand-supply balance of dollar assets.

Such a perfectly clear market signal can strike people as an entirely counter-intuitive proposition at a time of a quasi universal consensus that the Fed should continue to shrink its huge balance sheet.

Ultimately, as always, the Fed will solve this particular dilemma in terms of its policy mandate for growth and price stability. And the silver lining for the Fed is that a strong dollar gives it an extra degree of freedom in pursuing interest rate normalization, because it takes away the urgency for policy change.

Fed's technical move?

That's what the Fed may be thinking about at the moment. Here are some indications in support of that hypothesis.

Between August and November of last year, the Fed reduced its balance sheet by $244.6 billion – a clear sign that the long process of widely expected liquidity withdrawals was under way. But then, the Fed partly reversed that action in the course of December by expanding its monetary base by $104.1 billion. And that expansionary policy posture was also maintained at the beginning of January.

The question is: Was that a year-end technical move to accommodate balance sheet fixes in the banking sector, or was that a policy change of wider significance?

The answer will have to wait until the next reserve reporting date later this week.Meanwhile, the Fed's money market operations now indicate a much greater volatility than in the past few months, but the average effective federal funds rate of 0.11 percent since the beginning of the year remains well below its 0.25 percent target.

The U.S. bond market shows a very similar pattern: A significant volatility, with the yield on the benchmark ten-year Treasury note ending up at 1.84 percent last Friday -- 35 basis points below its level at the beginning of the year.

Investment thoughts

A very strong global demand for dollar assets gives the Fed time to proceed toward its goal of medium-term inflation and growth stability without undue haste.Slowing that process would be a mistake. This is a good time to keep moving in order to protect growth and price stability consistent with American economy's -- already stretched -- capital and labor resources.

Growing geopolitical instabilities and Europe's mayhem will benefit dollar assets for their intrinsic and safe-haven qualities.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.