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.
The timing and pace of rate hikes will be determined by:
- How rapidly the U.S economy approaches the Federal Reserve’s definition of “maximum employment”,
- Whether inflation proves to be above trend, and
- Whether growth is robust enough to support it.
Currently employment in the U.S is still well below pre-pandemic levels and the expectation is that the labour market will only reach full employment sometime in 2023. Growth in the U.S remains fairly strong but has likely peaked. Most of the nation has lifted the remaining pandemic restrictions on activity after a successful vaccination program, and fiscal policy is still providing a boost to growth. The Federal Reserve’s updated economic projections call for real GDP growth to reach 7% this year, 3.4% in 2022 and 2.4% in 2023. As we see the rotation of global growth from the U.S to the rest of the world, we should see the dollar come under renewed pressure. Although a hawkish path of interest rates will support the dollar, for now, the dollar will be caught in a tug of war between shifting federal reserve expectations and robust global growth over the next 6-12 months. See Figure 2.
The United Kingdom is set to experience robust growth over the next 12-18 months following a successful early vaccination campaign. Consumer confidence remains resilient, while business confidence and investment intentions have taken a notable turn higher as well. The housing market has also started to heat up, with house price inflation accelerating. A short-term setback to growth momentum however is the decision taken by the U.K government to delay “Freedom Day”, when all remaining COVID-19 restrictions would be lifted, into July because of the spread of the Delta virus variant. Nevertheless, the backdrop still points to above trend growth in the U.K over the next two years. Currently the expectation is for the Bank of England to begin raising rates in May 2023. See Figure 3.
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.