Although policy rates rise, the dollar could still fall

The first is that history actually shows that the dollar usually declines when US rates rise. The second is that the Fed has lost some of its anti-inflation credibility, and hence, even as policy rates rise, the dollar could still fall.

Many financial experts have spoken before about how history shows that the dollar usually declines against other G10 currencies when the Fed lifts rates. The reasoning behind this is that Fed rate hikes often convey a positive message about US economic growth—and hence global growth—and that actually emboldens investors on a global basis. As a result, riskier currencies in the G10 space tend to rise against the dollar.

Mr. Steve Barrow said the message that the Fed is sending out right now with its (imminent) rate hikes is not a positive one about growth, but actually a negative one about how the Fed might have fallen behind the inflation curve. As such, he might expect this particular tightening cycle to have a better chance of lifting the dollar should rate hikes depress global growth hopes and so lead to risk aversion among global investors. However, there are two reasons to question this outcome.

The first is that we’ve already seen expectations for Fed tightening surge over the past few months, yet the dollar has not rallied. At the start of the year, overnight interest swaps (OIS) were priced for 3 rate hikes (of 25-bps each) this year. Now the market is priced for more than 6 and talk of 50-bps hikes and intermeeting increases has mushroomed. The fact that the dollar has largely flatlined through all this is not a good sign for when the expected rate hikes are finally delivered. This poor dollar reaction may reflect the fact that the Fed has lost some of its anti-inflation credibility by allowing inflation to rise so far without any monetary response. In fact, the Fed is still easing policy given that it is reinvesting maturing treasuries. Of course, others, such as the ECB, are still easing and inflation has shot above target as well. Surely this suggests that many central banks could have lost credibility, not just the Fed. While that’s possible, we think the Fed is in the most troublesome place for a number of reasons.

The second reflects that the dollar has not risen despite much more aggressive US rate hike expectations. Another is that the Fed altered its policy mandate in August 2020 to tilt it in a more dovish direction. This was done to deal with undershooting inflation when, in fact, the problem it faces now is overshooting inflation. Yet another factor is that many other central banks, particularly in emerging markets, have started tightening well before the Fed, and often when their inflation threat is far less. In the Fed’s defence, it is appropriate to point out that market-based inflation expectations in the US have not risen materially more than in others, such as the euro zone. This may suggest that the Fed does not have a credibility problem. But Mr. Steve Barrow is very wary of reading too much into market-based expectations because not only have they been hopelessly wrong, but bond markets themselves are compromised by the hefty central bank interference from quantitative easing. Longer-term consumer-based US inflation expectations are also used by defenders of the Fed to argue that the bank has not lost the inflation plot.

But what do consumers know about future inflation? Most expectations just tend to get dragged along with actual inflation. In other words, it is hard to argue that inflation expectations are anchored when this ‘anchor’ tends to get dragged along. As Mr. Steve Barrow said before, this is an issue that impacts other central banks and their anti-inflation credibility as well. But the Fed still seems poorly placed in our view. And finally, we should not forget that its ability and willingness to restore credibility with an unexpected monetary policy shock is likely to be lacking, as it will want to avoid global financial market dislocation. That’s a burden that other central banks do not have.