This month we look at three major central banks within the developed market (Federal Reserve, Bank of England, and the European Central Bank) and the cyclical forces influencing monetary policy decisions on each. Monetary policy decisions (decisions on interest rates and asset purchases etc.) of a central bank are an important driver in currency markets. However, it is often more valuable to weigh them up against one another as opposed to looking at each in isolation.

The Federal Reserve jolted markets this month at the Federal Open Market Committee meeting (FOMC) where it signalled that it may raise rates twice in 2023. This proved to be a mildly hawkish surprise and was in contrast to the tone of the March meeting where the Federal Reserve projected no hikes until 2024. Seven of 18 committee members expected “lift-off” as early as 2022, up from four in March. Only five participants expected the Federal Reserve to start raising rates in 2024 or later, down from 11 previously. The Federal Reserve also revised its inflation forecast upwards for 2021, from 2.4% to 3.1%, while noting this still as transitory. In a press conference following the meeting, Chairman Jerome Powell acknowledged that FOMC members had discussed scaling back asset purchases. The reaction in the FX markets following the meeting was significant. The dollar surged in what we believe to be a knee jerk reaction to the meeting and not necessarily a change in the long-term outlook for the dollar. For one, market interest rate expectations between the US and the rest of the world are largely unchanged, as real rates moved higher almost everywhere within the G10. See Figure 1.

1. How rapidly the U.S economy approaches the Federal Reserve’s definition of “maximum employment”,
2. Whether inflation proves to be above trend, and
3. Whether growth is robust enough to support it.

The forces at play within the Eurozone are slightly different. While the euro area is enjoying a rebound in growth following the easing of pandemic restrictions, the overall euro area unemployment remains high at 8%. Inflation dynamics also remain weak with core inflation at a mere 0.9%. This proves that there is ample spare capacity in the euro area economy and labour markets. In an environment like this the European Central Bank is not under pressure to turn hawkish and so the prospect of interest rate hikes remains lower than that of the U.S and the U.K. Due to the lack of interest rate hike prospects, any rally in the euro from current levels will be a slow adjustment towards its fair value. See Figure 4.