The message from central banks

by Sean Tweedie | September 29, 2021

This month saw several Central Bank meetings take place. Bank of Japan, Swiss National Bank, Bank of England, South African Reserve Bank, and the Federal Reserve were a few. Of these the most closely watched by investors was the Federal Reserve.

The Federal Reserve proved slightly more hawkish following this month’s Federal Open Market Committee (“FOMC”) meeting compared to June’s. The key change was an upgrade to dot plot with half the committee now expecting at least one interest rate hike in 2022, and around 7-8 hikes by the end of 2024. The second key development was that tapering could begin at their next policy meeting which takes place in November this year. Tapering refers to a reduction in the rate at which the Federal Reserve purchases new assets (such as bonds) and is effectively the first step towards a reversal of Quantitative Easing measures. Bond purchases have added more than $4 trillion to the Federal Reserve’s balance sheet, which currently stands at $8.5 trillion. These asset purchases have helped keep interest rates low and have provided support to the market following the downturn.

The market’s response to the meeting saw the two-year U.S Treasury yield rise by 4 basis points which in turn boosted the dollar in a knee jerk reaction. This was a fairly muted response to the news. The market already expected rate hikes to begin in 2022 and so tapering this year was on the cards. See Figure 1.

Figure 1

It is also worth noting that other central banks are well ahead in reducing stimulus measures. The Norges Bank hiked interest rates by 25 basis points. The Riskbank will end asset purchases this year. It also closed all lending facilities launched during the pandemic. The Bank of England kept monetary policy unchanged but has already purchased £852bn of its £895bn target for government and corporate bonds meaning an end to Quantitative Easing measures is close. The Bank of Canada has already cut its asset purchases in half, the Reserve Bank of New Zealand has ended Quantitative Easing, and the Reserve Bank of Australia has also been tapering asset purchases. This shows that many of the Federal Reserves G10 counterparts are well ahead in their efforts to exit emergency measures. See Figure 2. The message from most Central banks is quite clear, there will be less monetary accommodation provided as economic activity picks up.

Figure 2

Central Banks look primarily at two major factors in their policy decisions. The outlook for growth and how it impacts employment, and long-term inflation. From a growth perspective the outlook is slightly uncertain, primarily because of the Delta variant of COVID-19 together with supply disruptions that impact manufacturing. In relative terms growth is rotating from the U.S to other economies which will be supportive of those economies’ currencies and negative for the dollar. The dollar tends to depreciate when U.S growth is relatively weak compared to global growth. See Figure 3. The reason that growth is picking up at a greater rate outside the U.S is due to these economies having been in various forms of lockdown over the past few months and now that they are opening, economic activity in these economies will rise.

Figure 3

Inflation in the U.S remains above the Federal Reserve target of 2%. Traditionally this would prompt a central bank like the Federal Reserve to increase interest rates. However, the Federal Reserve regards this increase in inflation as transitory and so has not responded as one would have thought. There is however a limit to how much of an overshoot they are willing to tolerate before intervening. This may mean that the Federal Reserve raises rates sooner or faster than what is currently being priced in the markets and thus could lead to an appreciation in the dollar sooner. That being said inflation is above target in quite a few other G10 countries, and so the issue of higher inflation is not strictly a U.S one. As mentioned above, other central banks are already cutting back on asset purchases and so should be in a position to raise interest rates sooner than in the U.S.

If these views hold true; that growth does recover faster outside the U.S, and those central banks follow an orthodox approach to policy decisions and so begin raising rates sooner, it will prove a headwind for the dollar leading to dollar depreciation.


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