The Federal Reserve has kept interest rates near zero since December 2008 in an effort to stimulate the U.S. economy; however, given current market conditions, investors expect the Fed to start raising short term interest rates by the end of 2015. The unemployment rate has been declining and factory activity has been increasing. In February, the U.S. Manufacturing Purchasing Managers Index measured at 54.3. Not only is this higher than January’s reading, but a number greater than 50 signals economic expansion. But despite several positive economic indicators, the current strength of the U.S. dollar (USD) and recent weak U.S. consumer spending have both been putting pressure on gross domestic product (GDP) growth. These two factors alone could influence the Fed’s decision on when would be the appropriate time to start raising rates.
Year to date, the USD has been strengthening relative to many foreign currencies. A strong USD makes imports more attractive to U.S. consumers and U.S. businesses, since foreign products are now less expensive. This also means that U.S. exports are becoming less attractive, since U.S. products are now more expensive for foreign consumers and foreign businesses. Net exports (exports minus imports) is a component of GDP, so the combination of falling exports and rising imports will slow down GDP growth. Net exports, however, is a very small percentage of GDP.
On the other hand, personal consumption accounts for approximately 70 percent of GDP. Given that gas prices have been falling and employment has been increasing, it is reasonable to expect a strong jump in consumer spending; however, this is not exactly the case. Retail sales in January did not increase as much as expected. This indicates that consumers are not spending the extra income they are saving at the pump. It may also indicate that the decline in unemployment is misleading. It may be that workers who were previously full-time employees are now only working part time.
Since it is very possible for the strong USD and weak consumer spending to drag down GDP growth, the Fed’s actions and decisions become more difficult. For example, if the Fed were to start raising interest rates in the next few months, it would be difficult to justify since declining GDP growth signals the economy is losing strength. It will be interesting to see just how patient the Fed remains with regards to when an increase in rates would be appropriate.
Feb. 27, 2015