Fed must do its best for US economy, which means hiking rates

William C. Dudley, Janet Yellen and Stanley Fischer in Jackson Hole last year.
Sabrina Korber | CNBC
William C. Dudley, Janet Yellen and Stanley Fischer in Jackson Hole last year.

Being by far the largest transactions and store-of-value currency, the dollar is a direct and powerful transmission mechanism of American monetary policies to the rest of the world.

This rather unique situation, where a national legal tender also serves as a currency of choice in most global flows of trade and finance, remains a hotly debated issue. I shall put to the side the political aspects of that discussion in order to concentrate on economics.

And the key economic policy question is this: Since the dollar is the world currency, should the Fed's decisions be couched in terms of global economic issues, or should the Fed just focus on the U.S. economy?

To confuse the gallery, the argument is often presented as a dollar dilemma: "Defend" the dollar (with rising interest rates) and damage the U.S. economy, or let the dollar go where it may (aka, the dollar's "benign neglect") to "protect" America's economic growth.

A false dilemma

In fact, there is no dilemma. The Fed does best for U.S. national interests and for the rest of the world when it lives up to its own policy mandate.

What? I can hear the howls about the simplistic (and jingoistic?) "America First" ideas. So, please let me explain by using the Fed's mandated policy objectives about growth, employment and price stability.

With its 35 percent share of the total output in the industrialized world, and its external sector amounting to nearly one-third of GDP, the U.S. remains the principal mover of global demand and employment. Even with a weak 1.5 percent annual growth in the first three quarters of this year, America was still making (in the 12 months to August) a net contribution of nearly $750 billion to global economic growth.

Who says better? Nobody …

Over the same period, China was taking out of the rest of the world a whopping trade surplus of $570 billion. During the same interval, the euro area was also living off the rest of the world with a trade surplus of $290 billion – 96 percent of which was accounted for by Germany, the Europe's lecturer-in-chief on how to live well with austerity, employment-killing structural reforms, rising poverty and chaotic immigration policies. Just don't ask Hungary's (dissenting) Prime Minister Viktor Orbán for comments on any of these lecture points.

Now, imagine how much the East Asian and European free-riders are rubbing their hands with glee knowing that the Fed will continue to provide strong support to American jobs and incomes. Price stability and the dollar's stable purchasing power are the two faces of the same coin. Both are monetary phenomena, and both are binding constraints on Fed's policies.

Here is what that means.

Price inflation begins to accelerate – and the dollar's purchasing power takes a dive - if the Fed maintains the monetary stimulus well past the point where the economy needs it. When that happens - ideally, much before that happens - the Fed has to start withdrawing its excess supply of money to slow down price inflation and to restore the dollar's position as a reliable store of value.

But that is easier said than done. Bringing inflation down typically leads to slowing economic growth, stalling employment creation and eroding incomes – provided the Fed is lucky (i.e., has a "perfect foresight") in calibrating the extent and the duration of policy restraint. Otherwise, we have a nasty recession and the usual merry-go-round with binary outcomes – rising inflation and/or recessionary slippages.

The winning trio

It is easy to see, therefore, that there is no dilemma here. America's steady economic growth, stable prices and the greenback's stable purchasing power are good for Main Street, Wall Street and the rest of the world. One may even be forgiven for boasting with that fellow New Yorker running for office that "What is good for America is good for the world."

There are two important issues here.

One, the Fed cannot do all this alone. That is why – ideally – the Fed would have to carefully coordinate its credit stance with fiscal, trade and structural policies of the new legislative and executive authorities. In fact, the Fed will probably have to coach the incoming rookies about an optimal monetary-fiscal-trade-structural policy mix to quickly lift the country's sustainable (i.e., potential) growth to 3 percent from the dismal 1.7 percent at present.

Whoever told Donald Trump that the growth rate should be 6 percent must have his/her head examined, or allow a German-style unbridled immigration - but letting into the U.S. only (massive numbers of) highly qualified and readily employable people.

Two, given the failure of G7, G20 and the IMF to make any meaningful progress on international policy coordination to reduce currently observed huge trade imbalances, the Fed could help by establishing its own policy discussion channels with the ECB and the PBOC (China's central bank) during bimonthly meetings at the Bank for International Settlements (BIS – aka, the central bank of central banks) in Basel, Switzerland.

That is an interesting forum where nations' money managers don't have to take back seat to finance ministries. The Chinese and euro area monetary policies are fully reflecting these regions' broader policy issues. The Chinese, in particular, seem to be coordinating effectively their monetary and fiscal policies. Sadly, that is not what is happening in the euro area, but the ECB is putting up a fight to offset cyclically ill-advised fiscal restraints.

There is plenty, therefore, that the Fed, the ECB and the PBOC – representing 55.5 percent of the world economy - can discuss to align their policies in order to maximize global economic growth by reducing business cycle disparities and excessive trade imbalances.

Investment thoughts

Those who don't wish to look beyond the next interest rate move can be reassured that the Fed is "making haste slowly" in that direction. During the reserve reporting period between September 28 and October 26, the Fed's liabilities were cut by $143.4 billion from their September averages. That brought them down 11.5 percent from the year earlier.

The bond market is getting the message. Yields on the benchmark ten-year U.S. Treasury note shot up 22 basis points since the beginning of October. But the Fed continues to hold steady, and well below the official target, the cost of funds in interbank markets.

Looking beyond the next 25 basis point pinprick, once the elections are out of the way, it is clear that a moderation of the Fed's monetary stimulus will have to continue. Some support to stabilize the economy must come from fiscal, trade and structural policies. How will that look is impossible to say, because, at this point, the players and their intentions are the big unknowns.

Here is my guess. The readers of this column know that I have never been a fan of fixed-income assets in an environment where the Fed's crisis management had largely run its course. I continue to believe that equities are a much safer bet. The Fed, with the help of the ECB and the PBOC, still has a lot of work to do to lift the world's sagging output, demand and employment.

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