Is the Fed the world’s central bank or a domestic institution? As we see it, this is the key question for the Fed at its next meeting. The economic data since the last meeting, looked at in isolation, should lead them to continue hiking the Fed Funds rate – simply put, the unemployment rate now stands at 4.9%, and inflation has made further progress back to the target with core CPI at 2.2%. The charts below show the progress toward the dual mandate. On the employment side we look at the unemployment rate against the NAIRU measure. On the inflation side we use the sticky and flexible price series.

The Fed has made three things clear over the past year or so. First, they view the recent period of below target inflation as transitory and driven by moves in commodity prices. Second, they believe in the Phillips curve. Third, they think that even after a few hikes monetary policy will still be very accommodative. This interview with Stan Fischer is one example. The reason we use the sticky/flexible price series above is to illustrate the dilemma the Fed is facing. Clearly, flexible prices and headline inflation are impacted by the enormous drop in commodity prices, principally crude oil. The chart below adds the headline CPI number and the crude oil price change YoY to make the point.

Let’s look back at the two big central bank decisions of the last 10 years. First, the decision by the ECB to hike rates in the face of inflation in mid-2008, on the eve of crisis no less. Second, the ECB decision to raise again in mid-2011 while the Fed looked through the inflation numbers. These decisions were incredibly important. The Phillips curve is a useful model of the economy, but it is just that, a model. The focus currently on stubbornly low inflation and a broken Phillips curve appears misplaced. Economic models like these are guideposts rather than exact predictions, and certainly do not exist in a vacuum. There is no credible way that one can expect a more typical inflation path and the Phillips curve to work perfectly in the face of such a large move in oil prices – particularly a move driven by the supply side as cartel pricing has given way. The oil move is moving through the system, we are seeing inflation and wages beginning to move upwards. The Fed was right to look through transitory inflation in 2008 and 2011, and a purely domestically driven Fed would do so again from the other direction now – particularly as lower oil prices (all else equal) over the medium term are a positive shock to the US economy, at the margin reflationary.

But the Fed doesn’t operate in isolation. The dilemma they face is that the rest of the world is not looking as healthy as the US. While they may be able to look through low oil prices, is it harder to look past the growth slowdown in emerging markets, which are getting hit by a confluence of factors; low commodity prices, corporate dollar debts as their currencies depreciate, and often the overhang of domestic credit booms? The risks are not binary here, but exist on a scale. The Fed could continue tightening, accepting the risk they may overtighten and be faced with exacerbating a global downturn. The consequences of this would be serious, and the uncertainty around tools to deal with them is high. Or they could wait and accept accelerating domestically generated core inflation, running the economy hot for a while, more confident that they have the tools to deal with higher inflation later. It’s a more explicit acknowledgment that the rest of the world is as large a driver as the domestic situation. Quite the dilemma. Should the Fed set policy for the US, or for the world?