Fed Ignores Dog, Focuses on Tail

The potential for a negative confluence of events is in the cards with the Fed looking back instead of forward.

Federal Reserve Bank of Cleveland: Exchange-Rate Pass-Through and US Prices

Still, large exchange-rate movements can induce price effects, as we are beginning to see. From its trough in early July through the end of December 2014—a date that facilitates comparisons with available import-price data—the dollar appreciated 9.0 percent on a broad trade-weighted basis. Over that same period, total import prices fell by 9.7 percent, but nonpetroleum import prices fell only 1.3 percent. Our rough estimates of the effects of exchange-rate changes on nonpetroleum import prices suggest that virtually the entire decline in these prices reflects the dollar’s appreciation. (We estimated a 1.6 percent change in nonpetroleum import prices, all else constant.) A further drop seems likely in February.

Estimating the impact of the dollar’s appreciation on consumer prices—as passed through from import prices—is very difficult because it depends critically on what is causing the exchange rate to change in the first place. Higher inflation abroad, for example, might lead to an immediate dollar appreciation and—for a time—lower dollar import prices. The appreciation could have a temporary, broader effect on US consumer prices, but it would not cause deflation in the United States. That would require a tightening of US monetary policy. In the present situation, the dollar’s appreciation seems largely the result of an anticipated tightening of US monetary policy relative to monetary policies abroad and that tightening itself may eventually affect US consumer prices. The appreciation in part seems a near-term conduit of that change, not so much an independent cause, because exchange rates typically react faster to expected monetary-policy changes than goods prices.
Bottom line:
Exchange-rate movements have always had less of an effect on US import prices than on other countries’ import prices because roughly 95 percent of the goods coming into the United States are priced in dollars, not in foreign currencies, making them impervious to the vicissitudes of exchange rates.

China Accounts For 90% of U.S. Non-Energy Trade Deficit
In Janaury:
Petroleum trade deficit was around $10 billion, which makes the Chinese trade deficit 89.9% of the non-petroleum trade deficit.
China's accounting differs from U.S. accounting and the Chinese method is more accurate of actual costs, but at the end of the day, the stronger dollar isn't going to touch of a big increase in the trade deficit. As long as the dollar doesn't keep rising and the yuan keeps its dirty peg.

Meanwhile, the Fed is focused on employment.

The Economist: Jobs matter, not the dollar
The US participation rate rose pretty steadily from the mid 1960s to the late 1980s, flattened out in the 1990s and then fell after 2000. It is currently well below pre-crisis levels, at 62.8%.

If the decline in the participation rate is cyclical, then more people will rejoin the workforce shortly; this will keep downward pressure on wages for longer, making it less necessary for the Fed to push up rates. But if the decline is structural, then the NAIRU may already have been reached and inflation will start accelerating; the Fed should act soon.

In a February 2014 speech, Mr Bullard reviewed the issue. The numbers are big, as he pointed out; at the time, 145m people were employed, 10m counted as unemployed and 91m people counted as non-participating. So a shift in the ranks of those participating can have a big impact.
Young people are 40% of the decline:
Demographic factors affect both ends of the age scale. Between 2000 and mid-2014, the proportion of 16-24 year olds participating in the workforce fell from 66% to 55%. By itself, this trend is responsible for around four-tenths of the decline in the overall participation rate.
At the other end, the participation rate for seniors is lower, even if it is rising.
Mr Bullard clearly accepts the demographic story; hence he believes there is less slack in the labour market than his colleagues think. The recent wage rise at Wal-Mart may herald a change in trend. His colleagues are waiting and seeing. But if they accept his argument, the Fed may have to act more quickly than markets expect.
Employment is a lagging indicator in the economy though. Mish has a timely post up today:

Jobs and Employment: How Much Recession Warning Can One Expect?
How Much Warning Can One Expect?

The answer is clearly none.

In the previous five recessions, jobs peaked two months after the start of the recession once, one month later once, one month prior twice, and once during the recession month.

In the previous five recessions, employment peaked one month after the start of the recession twice, one month prior twice, and once during the recession month.
The Fed has already waited to long to raise rates. If Bullard is right and there's no large increase in labor participation, wages are going to start rapidly climbing for the workers who are in demand. A Fed rate hike will do nothing to slow the oncoming inflation train. If the Fed is wrong on jobs, the economy will dip into recession as the inflation illusion rapidly fades amid a continued U.S. dollar rally. If the Cleveland Fed research holds up and there's a structural reason the U.S. trade deficit will not increase, the world's emerging market USD debtors will remain "short" of dollars longer than expected, fueling an even stronger than anticipated U.S. dollar rally.

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