The Most Important Least-Noticed Economic Event of the Decade

When Federal Reserve officials meet eight times a year to set interest rate policy, their job, assigned by Congress, is to figure out what is best for the United States economy.

Their job isn’t to set a policy that will be best for China or Brazil or Indonesia. Entering 2015, things were looking pretty good for the United States. Inflation was below the 2 percent level the Fed aims for, but the traditional economic models on which the central bankers had long relied predicted that it would start to rise thanks to a rapidly falling unemployment rate.

Even when prices for oil and other commodities started falling in the middle of the year, the Fed’s models viewed it as a positive for the overall economy.

Sure, some oil drillers and farmers might experience lower incomes, but consumers everywhere would enjoy cheaper gasoline and grocery bills. Although officials spent a lot of time monitoring the global economy, the fact remained that the United States wasn’t as dependent on exports as many smaller countries.

The 2008 financial crisis had shown how the American and European banking systems were deeply intertwined, but the same couldn’t be said of the ties with Chinese banks.

In other words, through the summer of 2015 it sure looked to many Fed officials as if the sound move was to start raising interest rates.

At the Treasury Department, which is responsible for the United States’ currency policies, it seemed well into 2015 that the strengthening dollar was mostly benign.

“There was a sense that the U.S. was doing well and the rest of the world was not doing very well,” said Nathan Sheets, a Treasury under secretary at the time and now chief economist at PGIM Fixed Income. “It was driven by strong U.S. fundamentals.”

But in late summer 2015, financial markets started to react more violently to the feedback loop of global currencies and commodities.

It started to seem as if some of the old rules of thumb — about how a rising dollar or falling oil prices might affect the economy — might not apply. Perhaps the economics models used by forecasters had become outdated, failing to fully account for the ways surging energy production had become more intertwined with the manufacturing sector and the financial markets.

“These things were all interconnected in different ways, and they all cycled back on the same industries and parts of the economy,” said Jay Shambaugh, a member of the Obama White House Council of Economic Advisers at the time.

Still, distilling that complex story into crisp memos for senior officials was no easy task.

“You have to make memos short and to the point in the White House, and it was hard to say what exactly we thought was happening,” he said.

Behind closed doors at the Fed, officials started debating whether this outburst of volatility in markets really posed a risk to the overall economy. Should they stick to their plans to raise interest rates steadily, or slow down?

Over two days in October, the debate played out publicly. Stan Fischer, the vice chairman of the Fed, was reluctant to adjust the planned rate increases, not wishing to let swings in financial markets dictate policy.

“We do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy,” he said in a speech in Lima, Peru, on Oct. 11, 2015.

Lael Brainard, a Federal Reserve governor who had worked on international issues at the Treasury, was quite a bit more worried.

“There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions,” she said on Oct. 12 in Washington.

Ms. Brainard was right.

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