Fed's Own Dollar Index Gives Yellen Reason to Raise Rates Slowly

  • Policy makers acknowlege currency level as economic headwind
  • Dollar surging vs euro, Aussie; Fed gauge highest in 12 years

The surge in the dollar that helped convince the Federal Reserve to refrain from raising interest rates until at least December also supports the notion that it will be a shallow path higher. 

The dollar climbed to a 12-year high this month, according to an index the Fed created to track the U.S. currency versus the nation’s biggest trading partners. The trade-weighted appreciation comes mostly against major exporters including Europe and China. Futures indicate the federal funds rate will reach about 0.81 percent by December 2016, while the most recent estimates from Fed officials in September show they expect to raise rates by about 1 percentage point next year.

Currency strength is a dilemma for Fed Chair Janet Yellen as policy makers prepare to boost rates from almost zero. The dollar’s surge, which reduces the cost of imports and makes it harder for prices to rise enough to reach the central bank’s 2 percent inflation goal, may damp the pace of rate increases and punish the U.S. currency against its major counterparts.

Strong Dollar

“The Fed’s already mentioned in some recent statements that they are concerned about the impact of a very strong dollar,” said Lutz Karpowitz, a senior currency strategist at Commerzbank AG in Frankfurt. “That means that the moment the dollar appreciation would be too strong, the Fed would adjust its monetary policy. The rate-hike cycle could be even more cautious than the market so far expects.”

The dollar has gained 10.4 percent this year, according to Intercontinental Exchange Inc.’s U.S. Dollar Index. It will drop 1.3 percent to 98.4 by the end of the year, according to the median estimate in a Bloomberg survey.

Fed View

Comments by high-ranking Fed officials on the dollar’s level and monetary-policy decisions have become more explicit and formal. 

The decision to delay raising rates has helped offset headwinds caused by a strengthening dollar, Fed Vice Chairman Stanley Fischer said in a Nov. 12 speech. Restrained growth owing to the dollar will persist well into next year and spell continued weakness in the traded-goods-producing sectors, he said.

“In years past, the only people that have talked about the dollar were in the Treasury and the only thing they would say is a stronger dollar was in the U.S.’s interests,” said Daragh Maher, head of U.S. foreign-exchange strategy at HSBC Holdings Plc in New York. “What we’ve seen over the course of 2015 is a Fed that’s happier to highlight what a stronger dollar means in terms of economic growth, inflation and rates. And Fischer’s speech is part of that strategy.”

Evidence of the dollar’s effect on the economy includes making U.S.-produced goods less attractive in overseas markets. Exports totaled $188 billion in September, down 5 percent from an all-time high in October 2014, according to Commerce Department data.

International Competition

U.S. companies also face increased international competition. Prices of non-oil imported goods tend to fall 3.2 percent for every 10 percent appreciation of the dollar, according to an analysis released on Wednesday by New York Fed researchers Thomas Klitgaard and Patrick Russo.

While considering the currency’s effect on the economy, the Fed lacks full control. Global central banks have been cutting borrowing costs and adding monetary stimulus to keep their economies afloat, making currencies less attractive versus the greenback.

The European Central Bank may boost its stimulus programs as soon as next month as inflation wanes and economic prospects worsen. The Bank of Japan kept its unprecedented easing program unchanged on Nov. 19 after a report showed the country slipped into a recession in the third quarter. China, the world’s second-biggest economy, has cut rates five times in 2015.

In assessing the dollar’s strength, the Fed’s traded-weighted gauge has a different composition than other measures that investors reference.

The ICE U.S. Dollar Index, which serves as the underlying asset for various derivatives, has a 58 percent weight to the euro and 14 percent for the yen. It lacks representation from any emerging markets, which account for more than half of the U.S.’s total trade flow.

The central bank’s index measures the greenback against the currencies of 26 economies according to the size of bilateral trade. China, Mexico and Canada make up 46 percent of the gauge. 

The greenback climbed to 71.97 cents per Aussie dollar on Monday, after falling for two weeks. It advanced to as much as $1.0601 per euro, the strongest since April 15.

The Fed index, which is due for its weekly update on Monday, rose almost 3 percent in the past month, a pace comparable to the periods prior to March and September meetings. Policy makers reduced their forecasts for the federal funds rate at both meetings, with Yellen saying the strong dollar contributed to economic headwinds and the more gradual projected tightening path.

“If the Fed hikes while the rest of the central banks of the world are biased to ease or are actively easing, the dollar will surge and we’ve seen the effects on exports already,” said John Herrmann, director of U.S. rate strategy at Mitsubishi UFJ Securities USA in New York. “They’re going to have to stay very gradual.”

(An earlier version of this story was corrected to fix an erroneous date.)

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