The Fed Is Holding Back the Dollar

The central bank's decision to begin reducing its balance sheet is just one of many indicators that global monetary policy is changing.

Keep an eye on the euro.

Photographer: Matt Cardy/Getty Images

Ever since the Federal Reserve laid out the process of balance-sheet normalization in June 2017, the dovish declines in rate expectations of board members have been important marginal differentiating factors for future central bank policy. These changes underscored the institution's persistent over-forecasting of its policy rates. A more dovish federal funds rate policy trajectory could keep the dollar under pressure, even if the U.S. currency receives a boost after last week's Fed statement and balance-sheet normalization announcement.

Plus, monetary tightening is afoot globally. The Fed’s decision to begin the reduction of its balance sheet in October 2017 is just one of many recent indicators that the tide of global monetary policy is changing. On Sept. 6, 2017, the Bank of Canada surprised markets with a 25 basis-point rate hike, and on Sept. 14, 2017, the Bank of England hinted at future increases. Logically, Canada's dollar spiked on the Canadian central bank announcement, and the pound surged to near pre-Brexit levels on the Bank of England hints.

While Fed tightening has been largely priced in -- and perhaps overpriced when it comes to federal funds rate hikes -- a question remains: Could other foreign central banks surprise markets with an unexpectedly hawkish tone? The answer is yes, and the euro is one of the currencies to watch for monetary policy that risks becoming more hawkish.

Current euro-area economic strength hasn't been fully acknowledged, nor has it led to a statement about the potential to tighten monetary policy, even though there has been an impressive 50-month expansion in the euro-area manufacturing PMI, at the same time that the German Ifo has been at or near record levels in recent months. With the euro-zone economy on a tear, and German business sentiment at the strongest levels since the fall of the Berlin Wall, it seems increasingly likely the European Central Bank will join the consensus in tightening policy sooner, rather than later.

The dollar has fallen since December 2016, as the chances of tax reform, infrastructure spending and other fiscal stimulus have faded, removing the need for more proactive anti-inflationary Fed monetary policy measures. Plus, inflation has been modest, further justifying Fed member decisions to ratchet their own federal funds rate expectations lower.

The euro has been strengthening on trend since January on fundamental data and the subsequent technical support. But there hasn’t been an instantaneous surge -- or pop -- for the European currency, as there was recently for the Canadian dollar or the pound. So, where is the hawkish ECB surprise that sends the euro surging higher? Despite the success of the Alternative für Deutschland party in the German federal elections on Sept. 24 and the decline in the September Ifo, I expect it’s coming. And if the verbiage of the Bank of England or the actions of the Bank of Canada are any indication, it might be coming soon.


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