The Fed’s efforts to reflate the US economy are more successful than they look

Today’s purchasing manager index release from the Institute for Supply Management showed 60.8% of respondents expanding, the strongest level since the global financial crisis except for one month in early 2011. Comparable indices are rising around the world, and the latest reports have all exceeded consensus expectations.

Perhaps the Federal Reserve has been more successful at reflating the US economy than its own target suggests. The Fed wants to see the Consumer Price Index rising at around 2%, but all the inflation gauges have come in significantly lower. In the Fed’s simplistic Phillips Curve model, lower unemployment leads to wage gains, wage gains lead to more spending, and more spending leads to inflation. That broke down for any number of possible reasons. Asia Unhedged has catalogued some of them:

1. After the financial crash US workers are more risk-averse, that is, more concerned about job security than pay gains, and less likely to switch jobs for higher pay. Part of that might be due to the fact that workers aged 55 and older are now more than 20% of the workforce, vs. only 10% in the early 2000’s, and many are working because they can’t afford to retire. Prof. Edmund Phelps, the 2005 Nobel Laureate in Economics, observes that there is nothing natural about the so-called natural rate of unemployment, that is, the rate below which price pressures will appear. It’s largely a culture artifact and the culture has changed.
2. Technological change cheapens the cost of many goods.
3. Weak demand among lower-income households leads to sagging prices for some important spending categories, e.g. used cars.

We could go on. The CPI seems disconnected from monetary policy. But the dollar’s exchange rate is not: the Fed’s accommodation during the past year has allowed the dollar to depreciate against other currencies, providing a boost to US manufacturing businesses. We see this in the inverse relationship between the dollar index and the NAPM’s purchasing managers’ index.

Asia Unhedged created a simple model that predicts changes in the PMI by lagged changes in the dollar index. It turns out that the dollar index by itself gives a pretty fair prediction of the PMI, as in the chart below.

Of course, a cheaper dollar aids manufacturers by making them more competitive in global markets. But a weakening dollar is also a gauge of overall financial conditions. When money and credit are plentiful and interest rates are low, the dollar tends to fall, and vice-versa. The dollar index may be a better gauge of monetary stringency or ease than the skewed and misleading inflation data.

If this is the case, the buoyancy in the US manufacturing sector is attributable to benign financial conditions overall, not just to the effect of a cheaper dollar on exports.