The Fed and the dollarzone

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The Fed kept interest rates on hold this week and revised down its view on the pace of interest rate hikes going forward. Financial markets took it as a signal that the FOMC would likely continue to keep its policy rate on hold for most of this year and rejoiced, with emerging market equities starting to approach bull market conditions. On the face of it, the Fed’s decision to keep interest rates at near zero seems odd. After all, the unemployment rate is at levels that are not far from full employment and core inflation has started to approach 2%, so both aspects of its dual mandate appear to be (close to) being met.

Our central view remains that the Fed will remain on hold in the coming months, most likely through 2016 Nick Kounis Nick Kounis Head of Macro Research

  • The Fed kept interest rates on hold this week and revised down its view on the pace of interest rate hikes going forward
  • Wage growth has been subdued and demand has been lacklustre, but crucially the Fed is worried about global developments
  • The Fed is the nearest thing we have to a global central bank and many vulnerable economies around the world are part of the ‘dollarzone’
  • We continue to think the Fed rate hike cycle is on pause; meanwhile we have adjusted our scenario for the ECB and EUR/USD

So what is going on? First of all there are considerate doubts about how close the Fed is to its targets, because wage growth is subdued. This could signal that the unemployment rate can drop further without triggering inflationary pressures. In addition, although recession fears have abated, demand is still rather weak. Data published earlier in the week showed core retail sales were basically flat between February of this year and November of last year.

Introducing the world’s central bank

More importantly, the Fed is the nearest thing the world economy and financial system have to a global central bank. The FOMC seems to now be taking that role more seriously, with good reason. In its statement, the Committee noted that ‘global economic and financial developments continue to pose risks’. Of course every central bank needs to consider the global environment, but for the Fed it more important because its policy actually in part shapes that environment.

Setting policy for the dollarzone

In particular, many emerging market economies around the world are part of the ‘dollarzone’, either because their currencies are linked to the dollar or because their companies have significant outstanding dollar debt. Tighter monetary policy is the last thing these countries need. When the Fed raises interest rates, it has to consider to some extent that many economies are pressured to run a tighter policy to keep their currency relatively stable against the US dollar if they allow free movement of capital. The alternative is to allow for an easier monetary policy and allow their currencies to fall, which inflates the local currency value of their debts. This puts these policymakers in a difficult position. So the Fed’s pause from rate hikes is a relief for many other economies.

Parallels with the eurozone

The ECB sets monetary policy for the eurozone. Of course this is a more extreme situation than the dollarzone as there is one single currency and no wiggle room at all in terms of the monetary conditions set by the ECB. In many emerging markets, currencies are much more loosely linked to the US dollar. However, there are some interesting parallels. Back in 2011, the ECB raised interest rates by 25bp each in April and July, but reversed the interest rate increases by the end of the year. Back then, the German economy had been doing extremely well, but the debt-laden periphery was extremely fragile. Most peripheral countries fell into recession by the end of that year, while the eurozone eventually followed in 2012, as the euro sovereign debt crisis escalated. This is not to say that the same set of disastrous consequences would follow from Fed rate hikes. However, the lesson is clear: the central bank of the dollarzone needs to have some consideration for its vulnerable periphery as well as its stronger core in setting interest rates.

Fed likely on hold this year, ECB to focus on QE

Our central view remains that the Fed will remain on hold in the coming months, most likely through 2016. In any case it looks likely that when it does resume raising interest rates it will be at a snail’s pace. For this reason, we think that the US dollar rally of the last few years is behind us. Other central banks do not seem ready to move aggressively in the other direction in order to foster the conditions necessary for another leg of the US dollar upswing. Although the ECB announced a broad-based package of measures earlier this month, it signalled it was not prepared to cut its deposit rate aggressively.

Indeed, we now no longer expect further deposit rate cuts in our base scenario. A further ECB deposit rate cut would only be triggered on the back of a further significant surge in the euro in our view. While we do expect further monetary easing from the ECB given that inflation is still not on track to get back to its goal, this will probably take the form of a further stepping up of QE. We are projecting another EUR 20bn increase in monthly asset purchases later this year, most likely in September. Given that QE has less impact on currencies than negative rates, we raised our forecast for the EUR/USD. We now see it moving sideways in a range around 1.15, rather than falling to 1.05.

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