All eyes are on the Federal Reserve this week as it convenes for its latest two-day policy meeting. The central bank is under the microscope lately. Since late 2008, the Fed has held short-term interest rates at zero in an effort to stimulate economic growth. But it is expected to begin raising them in the coming months. The world has been looking for hints of when that will happen.
While all that's going on, something else historic is happening: the Euro is dropping and the dollar is appreciating ... so much so that the two may soon be equal in value. That has pluses and minuses: it's great news if you're an American who wants to buy Italian wine or a hotel room in Paris. It's bad news for US companies trying to sell their goods abroad.
But it's also a good reason for the Fed to be extra-patient about raising interest rates. A rising dollar and the cheap imports it makes possible will limit inflationary pressures, giving the Fed the breathing room it needs to focus on boosting economic growth.
A strong dollar means lower inflation
Low interest rates are one of the Fed's main tools for stimulating the economy — pushing the interest rate lower encourages borrowing, which encourages economic growth. It also helps send the stock market soaring. The Fed has used this tool aggressively, holding short-term interest rates near zero for more than six years.
Recently, as the economy has picked up steam, the Fed has been tightening its policy. It has wound down a program called quantitative easing that pumped more cash into the economy. It has tapered its QE3 program and hinted that it will raise interest rates in the near future.
The very fact that interest rates might rise is, first of all, causing stocks to plummet, as investors know businesses will soon have to pay more to borrow.
It's also helping send the dollar higher against other currencies. The US economy is going strong while other economies (Europe in particular) are not. This is good for US consumers in some ways — it makes imported goods cheaper, so now is a great time for Americans to buy European products and vacations.
Cheaper imports exert a downward pressure on prices — both the prices of goods consumers buy directly and of inputs American companies use in their products. A strong dollar also means our exports are more expensive for foreign consumers, which can dampen demand for American workers — and therefore upward pressure on their wages.
In short, the strong dollar will tend to push down the inflation rate. And inflation has already been running below the Fed's target of 2 percent.
Many Fed-watchers believe the Fed will do it as soon as June. They point to the fact that job growth has been getting stronger and stronger, with the unemployment rate down to 5.5 percent.
But raising rates could make the dollar even stronger, and that could both be a further drag on inflation and weigh on growth. That's an argument for keeping interest rates low. And that's just one of many.
The strong dollar isn't the only argument for keeping interest rates low
There are plenty of other arguments for the Fed keeping its hand off the interest rate lever. Congress has given the Fed a "dual mandate": keep employment high and prices stable. The Fed is doing a great job — arguably too good of a job — keeping the inflation rate low. And markets expect inflation rates to stay pretty low in the coming years. So why not focus on the other prong of its mandate: boosting employment?
It's true that unemployment has fallen to 5.5 percent, but wages still are just barely keeping up with inflation, as Vox's Timothy Lee wrote after the last jobs report. And there are also other signs of slack in the labor market. Full-time jobs are only just now getting back to pre-recession levels, and there are still more than two million more involuntary part-time workers than there were prior to the recession.
In short, we're still not at full employment. With inflation firmly under control, there's no real treason to talk about inching away from its job-creating zero interest rates just yet.