Brexit a knockout punch to Fed's interest rate divergence mantra

Fri Jun 24, 2016 2:03pm EDT
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By Howard Schneider

WASHINGTON (Reuters) - Britain's shock vote to leave the European Union may tie the U.S. Federal Reserve to near zero interest rates for far longer than expected, according to new research indicating the U.S. central bank is now tightly bound to international economic conditions.

Over the past 18 months the Fed has blinked more than once, and refrained from raising interest rates when global market volatility has darkened the economic outlook, but the Fed has still maintained that U.S. monetary policy could ultimately "diverge" toward higher rates even in a weakened world economy.

That idea may now have suffered its final blow.

Fed research published this week found a strong link between the movement of the long-run "natural" rate of interest in the U.S. and other developed countries, meaning the Fed may be forced to keep short term interest rates near zero until economic growth in other developed economies accelerates and the uncertainty around "Brexit" passes.

Other research has been begun documenting abnormally sharp moves in the U.S. dollar in response to monetary conditions around the world also.

With the U.S. dollar rising sharply on Friday after the Brexit vote as investors poured money into safe-haven assets, the Fed may be faced with a fresh drag on U.S. exports and job growth and another hurdle to reaching its inflation target. The dollar rose more than 2.0 percent on Friday against a basket of major currencies.

Taken together, the conclusions are bad news for a central bank that has staked its credibility on the need to nudge U.S. borrowing costs higher. The research is especially bad news for the Fed's ability to raise rates if the rest of the world remains a depressed amalgam of negative interest rates and slow economic growth.

The Fed's position is "extremely challenging..In the current global setting it will be extremely hard for the Fed to move long rates," said Massachusetts Institute of Technology economics professor Ricardo Caballero.   Continued...

The facade of the U.S. Federal Reserve building is reflected on wet marble during the early morning hours in Washington, July 31, 2013. REUTERS/Jonathan Ernst