In recent years, critics of the US Federal Reserve have grumbled that there have been (at least) two shortcomings in how central bank officials analyse the world. Firstly, the Fed’s econometric models have tended to downplay the role of money - and the ability of capricious markets to hurt the “real” economy. Second, those economic equations also tended to ignore the economy beyond America’s borders, since the Fed board has historically watched domestic data when setting interest rates.
Now, however, there are some intriguing hints of a change - in the Fed’s rate-setting perspective, if not those pesky models. Earlier this year, Janet Yellen, Fed chair, surprised investors by suggesting that turmoil in the Chinese financial markets was one factor why the Fed committee decided not to increase interest rates a second time (after raising them 25 basis points late last year).
This month it seems that a second non-American market issue could shape Fed debate again - this time in relation to Brexit. Last week Jerome Powell, a member of the Fed’s board of governors, suggested that the board might display “caution” about raising rates at its next meeting on June 15, because of the British referendum on June 23 on whether to leave the EU.
Separately, Dennis Lockhart, president of the Atlanta Fed, has noted that Brexit is a “real consideration” in determining whether it will raise rates in June. And while Ms Yellen has hitherto (wisely) stayed silent on the risks of a Leave vote, other Fed officials, including Daniel Tarullo, share Mr Lockhart and Mr Powell’s view that jumping ahead of the poll with a rate rise might be risky.
From a narrow macroeconomic perspective, this seems odd. After all, if you look at recent US data, there seems to be little reason to leave rates at the current negative real levels. Unemployment has now dropped to 5 per cent, in line with the Fed target, and inflation is 1.1 per cent. And while growth softened at the start of this year, it seems to be rebounding: this week’s consumer data showed its strongest reading for seven years.
Given that, a Brexit vote seems unlikely to dent the “real” US economy, even if the UK voted to leave the EU and this sparked a recession. After all, US exports to the whole of Europe - never mind Britain - are a mere 2 per cent of gross domestic product.
But what really worries some Fed officials is not the trade data, but the slippery matter of market psychology. If the UK voted to leave the EU, this could unleash profound investor uncertainty; indeed, if this leads to a wider break-up of the bloc it would be a “systemic” shock, in Fed parlance. Fed officials learnt the hard way in 2008 that in today’s tightly entwined global markets, market shocks have a habit of unleashing contagion in unexpected ways. They do not want to repeat the experience.
So the argument being batted around in some Fed circles is that the “cost” of delaying an interest rate rise from June to July (or the next Fed meeting) is much less significant than the risks of moving early. After all, a six-week delay is tiny compared to the length of time that rates have already been at rock-bottom. And a hasty move could be costly since it might signal to investors that the Fed was overly eager (or desperate) to raise rates, irrespective of market risks; or so the argument goes.
Is this a sensible stance? I would argue so. Waiting longer to raise rates certainly creates some risks: it leaves the US economy with an excessively loose monetary policy for longer; it may also create the impression that the Fed is becoming a hostage to global events, which could in turn create even more investor anxiety. But Brexit is a slightly unusual global event in the sense that it is binary, and pinned to a specific date. And given that the Fed has tended to pay too little attention to global market linkages in the past - rather than too much - the fact that it is becoming aware of these dangers seems laudable, not reprehensible.
Indeed, in my view the Fed should now go even further and use the Brexit issue to spell out how it intends to incorporate an analysis of those “market” and “non-American” issues into its broader analysis in the future. That would not be easy to define. But in a world of tightly entwined global markets, it is a fallacy to think anyone can run monetary policy on the basis of domestic real economy data alone. Just look at the past decade’s credit bubble and bust for evidence of that.
Or, to put it another way, the really big policy issue that Brexit has raised for the Fed will last far longer than the vote on June 23. For the time being, though, all eyes are on Ms Yellen - and that British polling data.
