In his WSJ op-ed last Friday, Noble Prize winner Ned Phelps reminds us:
“An even worse possibility [than inflation] arises from [loose monetary policy because of] the peculiar structure of the U.S. economy. It is highly integrated with financial markets overseas, so financial yields cannot differ much. Yet it is too large and too distant to depend much on exports and imports, so its prices may differ quite a lot. As in any open economy, an interest-rate cut by the central bank causes the currency to drop in foreign exchange markets. … The interest rate cut, in weakening the dollar, adds to their protection from entry by overseas competitors. The domestic firms promptly respond by raising their prices—their markups over wages, roughly speaking. This rise of markups, in shrinking the demand for labor, reduces real wage rates and employment.
The implication for Fed policy is clear: Through this channel, the continuation of easy money may be causing or contributing to the stubborn gap between output or employment and their trend paths—thus a lull in the growth of output and employment.
Do we see evidence of dollar weakness that could be traced to easy money? We do. The U.S. dollar was strikingly weak against the Chinese yuan until mid-2015, when China devalued. The dollar was weak against the euro too until early 2015, when the European Central Bank acted. There is also the high share of profits in business output in recent years, which can be attributed to the protection that dollar weakness has offered.”