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Fed shouldn’t be fazed by reaction to latest statement

You are a central bank.

You just have spent a couple of days thoroughly assessing the latest economic evidence. You have decided that the economy you oversee is advancing at a "solid" pace. Job gains are "strong," and the unemployment rate is falling steadily. A wider set of labour-market indicators shows the "underutilization" of the working population "continues to diminish." This is important because you had been very worried that too many part-timers were being denied more hours and that the longer-term unemployed were at risk of becoming permanently marginalized.

What's more, business investment continues to increase and a big drop in oil prices has "boosted household purchasing power." This also is significant because consumer spending represents more than 70 per cent of your economy's gross domestic product. The households you watch have spent the last five or six years paying off their outsized debts (or declaring bankruptcy). A windfall from cheaper energy means they are more likely to spend it, rather than use it to stay out of trouble with their banks.

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You decide to put all of these things in a statement and share it with the public. You observe stock markets in New York fall. The next day, Asian and European equity prices do the same. When all those economists insisted the exit from years of extraordinary monetary policy would be bumpy, perhaps this is what they meant?

You are, of course, the U.S. Federal Reserve, which must be moderately puzzled by the reaction to its latest policy statement Wednesday.

The Fed acknowledged that it is keeping an eye on "international" developments. But this should have been interpreted as a dampener, not the bottom line. Investors still appear to be trapped in that post-crisis mentality that bad news was good and good news was bad; bad news being the harbinger of looser monetary policy. That philosophy no longer is valid because things in the United States are getting back to normal.

This was the bottom line Wednesday: the world's largest, most dynamic, most resilient economy is as strong as it has been since the 1990s. The late Alan Greenspan period looked good at the time, but we know now that it was a mirage. The U.S. government had decided to lift its population out of poverty by orchestrating a once-in-a-lifetime investment boom, which was at its peak at the turn of the millennium. American households simultaneously went on a spending spree even as their incomes were stagnating. They masked by borrowing heavily, which seemed sustainable because interest rates were so low. It felt too good to be true, but many smart people assured the masses that it was okay. They called it the Great Moderation. But there was nothing moderate about the ending.

The Fed was one of the purveyors of the myth of the Great Moderation. That may explain why the Fed fought the recession so aggressively. It also explains why the Fed remains on track to raise interest rates even as the new fad among global central banks is surprise rate cuts. Alan Greenspan's Fed left interest rates too low during the boom years ahead of the housing bust and financial crisis. Current chair Janet Yellen will be extremely wary of repeating that mistake now that U.S. gross domestic product is surging at an annual growth rate in excess of 4 per cent.

As the Fed released its policy update, Singapore's monetary authorities became the latest to surprise financial markets with a loosening of policy. The Reserve Bank of New Zealand shifted from a neutral setting from a bias to raise its benchmark lending rate. The Bank of Canada defied consensus by reducing borrowing costs last week. Analysts at Royal Bank of Canada predict Australia's central bank will cut rates before the end of the year.

All of these are small, open economies that are dependent on trade, commodity prices or both. The European economy is stagnant and Chinese demand is slowing. The collapse in oil prices is curbing investment and putting extreme downward pressure on inflation. No one saw this coming and no one knows how long it will last. Central banks rightly are taking out insurance on a bad outcome.

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The U.S. is unlike any of these economies. It is uniquely diversified.

With so little demand at home, U.S. factories after the recession pushed into international markets, many taking exporting seriously for the first time. They — and the Fed — will be sensitive to the sharp increase in the dollar. Those companies also will be aware of what is going on in their backyards, where household "purchasing power" is getting stronger.

Ms. Yellen's Fed will continue to move cautiously. Inflation is well below the Fed's target, meaning there is less pressure to act quickly. And while the Fed will keep an eye on what's going on in the world, it will be far more concerned about what is happening at home. And at home, "solid" economic growth does not require a benchmark lending rate of zero.

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.

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