The global economy is forcing the U.S. Fed’s hand like never before

It used to be that the Fed could base most decisions on the U.S.’s domestic economy. That’s no longer the case

U.S. Federal Reserve chair Janet Yellen

U.S. Federal Reserve chair Janet Yellen in a press conference on September 17, 2015. (Win McNamee/Getty)

One gets the impression that the Federal Reserve’s leaders very much want to raise interest rates. “It was a close call,” John Williams, president of the San Francisco Fed, said on the weekend, referring to the Fed’s contentious decision to leave the benchmark rate at zero last week. Here’s why they balked at raising interest rates:

Chart showing the proportion of exports as a percentage of GDP.

That’s a picture of an important post-crisis change in the United States economy. The chart starts in the first quarter of 2000, when U.S. exports of goods and services equaled 10.5% of gross domestic product. That wasn’t a lot compared with other big economies. American companies were blessed with the world’s wealthiest and most voracious consumers just outside their doors. There was no need to export. The ratio of exports to GDP dipped below 10% for much of the decade. Then came the Great Recession. American consumers retreated and in order to survive, U.S. companies got serious about international markets. Aided by a weaker dollar, they started breaking export records, even as domestic consumption continued to languish. Overseas sales rose to almost 14% of GDP by the end of 2014.

The U.S. economy still is driven by domestic consumption. (Household spending equals about 68% of GDP.) But exports matter now.

As the chart above shows, American exporters stumbled at the start of 2015. Exports as a percentage of GDP dropped to 12.8% in the first quarter, compared with 13.6% a year earlier. And then U.S. exporters failed to get back up in the second quarter, as exports-to-GDP slipped to 12.7%. The Fed noticed. Even though the U.S. unemployment rate is at its lowest level since early 2008, America’s central bank opted to leave its policy rate unchanged last week. Fast deteriorating international demand was the main reason given.

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term,” the policy committee said in its post-meeting statement.

That’s mostly a comment on China. Janet Yellen, the Fed chair, said at a press conference that she’s concerned that the slowdown in the world’s No. 2 economy could be more “abrupt” than expected. But it’s more than China. Yellen also noted that other emerging markets are suffering, whether it be from weaker demand for exports, the collapse in commodity prices, or both. Even Canada entered the conversation as an “important trading partner” that is buying less American-made stuff because of its own struggles with $40-a-barrel oil.

There is a strong view that the Fed is creating big problems for itself at some point in the future by encouraging households, companies and investors to load up on debt. The opposing opinion is equally strong. Many think the Fed did the right thing by waiting because inflation remains remarkably tame—maybe even too tame. Policy makers released new economic forecasts last week that predict prices will rise 0.4% in 2015, compared with the Fed’s annual inflation target of 2%. Yellen told reporters that the Fed’s credibility “hinged” on meeting that target. Put that way, the Fed had little choice but to carry on as before.

The surprise last week was the degree to which the struggles of China and other economies factored in that decision. Yellen said specifically that international conditions were putting downward pressure on inflation. Rarely had the Fed worried much about what went on outside U.S. borders. For example, at the end of last year, Bank of Canada Governor Stephen Poloz called the risk of war between Russia and Ukraine a grave threat to his outlook. Yellen, by comparison, said she thought the impact of Russia’s recession and geopolitical isolation would be “small.”

Some analysts suggested Yellen and the Fed simply were spooked by volatile stock markets. They recalled the “Greenspan put” and the tendency of Yellen’s predecessor, Ben Bernanke, to seemingly adjust monetary policy to buoy stock prices. That may be too cynical. The current Fed chair said she felt this summer’s market volatility said something about confidence in global economic growth. The Fed’s decision to leave its policy unchanged was a recognition of something new: the U.S. economy is no longer an island.