Fed: About the Dollar

Published on March 11, 2015

In weighing the likely impact of the recent surge in the dollar on the Federal Open Market Committee meeting discussions next week, the distinction should be made, as the Fed has been striving to do in the recent spate of public remarks that followed Chair Janet Yellen’s Humphrey Hawkins testimony, between the decisions to adjust forward guidance and when to pull the trigger on a rates lift-off.

*** There is likely to be little if any dollar impact on a strongly felt FOMC consensus on the need to adjust its guidance language to maximize its policy flexibility beyond its April meeting. But the dollar surge could, on the margin, influence how the FOMC opts to drop or modify the “patience” language, and that could have mixed effects on the bond markets versus the currency markets. ***

*** A stronger dollar has long been forecast and so should also have a limited impact at most on the policy path. But again, there is a potential tactical near term impact, the quickening pace of the dollar strength is likely to further dampen near term goods inflation, while an offsetting uptick in services inflation, on the back of more broadly based wage growth, is not expected until late this year. That, in turn, we think could still eventually tip the balance within the FOMC towards a more cautious September first rate hike rather than June. ***

The March Guidance debate

In terms of the March debate over the fate of the “patience” language, a somewhat surprising strong consensus has come together — including among the more dovishly inclined — to drop or modify the patience phrasing so there is no doubt that after the April, the FOMC policy decisions will be on a “meeting to meeting” basis. That desire for maximum policy flexibility isn’t really going to be shaped one way or another by the dollar.

Where it could get interesting, however, is how the FOMC opts to make the guidance changes. A straight deletion of patience would be the cleanest, but the dollar strength could be used by the still hesitant Committee members to bolster the case to turn to opt for the December template of a two-step transition, that is, keeping the patience phrasing and adding the new language of a meeting to meeting assessment of the growth data and whether they can be “reasonably confident” in an upward inflation forecast – in effect, negating its stated “two-meeting” meaning guarantee.

And while the Committee may believe either still points in the same direction, its impact on the bond and currency markets may not be the same. A still skeptical fixed income market could take the two step guidance transition as confirmation of the widely held view the Fed is still very reluctant to hike, while the dollar-bullish currency markets could take it as a sign to slow the pace of its dollar buying.

The staff briefing at the meeting on the market sentiments and potential near reactions is likely to be the determining driver to how the policy flexibility is laid out in the statement. And it may ultimately be up to Chair Yellen in her presser to finesse the different market reactions.

Ideally, cooling a bit of the dollar fervor may not be such a bad thing even if directionally it remains the same; but at the same time nudging the bond market expectations closer to the Fed’s rates messaging may prove to be no mean feat.

What’s more, we are unsure whether the new blue dot rate plot will go with or against the intended messaging. For one, we do expect the longer run estimates for both unemployment and the neutral interest rate to be marked dovishly lower, while the core cluster of 2015 dots will probably be edged a bit lower even though rate hikes are more certain. No wonder neither she nor the staff look fondly to the quarterly press conferences.

The Rates Lift-off Window

The impact of the dollar on the actual decision for the long awaited rates lift-off differs from the more tactical questions of the March meeting language decision.

For one, the dollar has long been forecast to strengthen, especially against the Euro, for some time now, and the only real surprise by late last year was that it took so long for the Euro to finally start weakening. And while its accelerated upward climb is eye-catching, it is likely to be seen as a front loading of the currency effects of the European Central Bank’s QE program rather than an overly alarming new trend.

The dollar’s strength, in other words, is unlikely to be seen as sustained enough or moving above the top end of the forecast range to alter the domestic growth projections or the degree of tightening in financial conditions to move the needle on rate policy. At least not yet.

As importantly, the Fed’s rate decisions, whether June or September, as well as its most likely base case of the tightening cycle, will incorporate where the dollar is forecast to be a year or more from now, not this month or the next quarter.

Furthermore, if the stronger dollar helps the European and Japanese recoveries, it is more welcomed than not by the Fed; more to the point, the dollar strength will probably ebb or at minimum stabilize further down the road if Europe and Japan do indeed start to show all the signs of recovering to the degree that is being assumed in the Fed forecasts.

With that in mind, the stronger dollar in the near term could, on the margin as always, tighten monetary conditions enough to tip the arguments within the FOMC to September over June for a rates lift-off to September, and it could even add to the case for the Fed to adopt an even more cautious approach in the initial pace of rate hikes.

But then the eventual recovery of Europe and Japan and the stimulus it would add to the momentum of US growth by next year would likewise suggest steeper rate hikes in the outer years of the forecast, all else being equal.

Complicating the Inflation Outlook

Where a faster rise in the dollar complicates the policy picture is how it is likely to have major near term effects on the breakdown in the core inflation readings across the “mid-2015” lift-off window.

The faster surge in the dollar coupled to the weakness in energy prices, is all but certain to weigh on goods inflation through most of this year, while an anticipated uptick in services inflation due to an eventual, broad-based wage growth, is unlikely to show up in the data much before near the end of the year.

Taking together, if the FOMC can draw from the data that will be on hand by the time of its June meeting that core inflation will be rising back towards its 2% inflation target or that Europe will indeed pull its act together enough to warrant a more upbeat forecast on foreign growth by next year, we would be very impressed by their confidence.

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