The Greenback and the Fed: A Supportive Relationship

June 19, 2017

On Wednesday, 14 June 2017, the Fed FOMC wrapped up a 2-day meeting. The decision to raise the federal funds rate (FFR) by 25-basis points was an important one. This marks the second rate hike of the year, signaling a dramatic change in monetary policy for the US since the global financial crisis. Currently, the Fed funds rate is 1.25%, precisely the level forecast by economists. Minutes of the Federal Open Market Committee (FOMC) will be released on 5 July 2017 at 6 PM GMT. There is now at least 1 more additional rate hike expected in 2017, and that will likely bring the interest rate to 1.50% heading into the new year.

How Strong Are US Economic Fundamentals?

The Fed has also upped its forecast for gross domestic product (GDP) growth for the year, from 2.1% in March to 2.2%. However, there is some concern about the inflation rate which continues to undershoot the Fed’s benchmark of 2%. For 2017, the PCE inflation figure is now 0.3% lower than the March projection, at 1.6%. This marks an important deviation from the strategic target set by Yellen and the FOMC. The implications of monetary policy on the USD are significant. Monetary tightening (raising interest rates) can increase demand for the USD, provided the fundamentals of the economy are sound, and growth projections are strong.

After the Fed decision to raise rates, there was no noticeable change to the USD. The dollar whipsawed briefly during the session on Wednesday, 14 June, but regained stability by the end of the day. The rather bullish sentiment expressed by Fed chair Janet Yellen helped the USD to strengthen against the JPY and the EUR. This is the fourth rate hike since 2015, and it is clear that the Fed’s prognosis of the US economy is markedly more positive. Recently, Wall Street witnessed a selloff in tech stocks and a return to banking and financials. Investors are even diversifying into lucrative digital assets like Ethereum, and other cryptocurrency options.

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Key factors to long-term US economic growth

Currently, the Fed has assets of approximately $4.5 trillion under its control. This is the largest ever balance sheet held by the Fed, and Janet Yellen is eager to start unwinding the Fed’s position. This will only take place on the proviso that the economy performs as expected. Yellen expects the federal funds rate to remain below optimal levels for the short to medium-term, based on economic data such as NFP (nonfarm payrolls), unemployment rates, GDP, CPI, and to a lesser degree, soft data releases like business and consumer sentiment. If the Trump administration gets the green light to move forward with infrastructure growth and development, deregulation, a taxation overhaul, and others, this could fast-track the performance of the US economy.

The USD Remains ‘Softish’

Currently, the US dollar index is trading marginally higher at 97.55. This broad measure of the strength of the USD against 6 other currencies (JPY, EUR, GBP, CHF, CAD and ACK) has advanced by 0.35% over the past 5 days. For the year to date, the US dollar index is down 4.72%. This dovetails with the general sentiment about the US economy – lukewarm at best. The failure of Trump Trade has sparked a negative run on the USD.

Several analysts are a little perplexed about Yellen’s fixation on inflation vis-à-vis the Phillips Curve as opposed to US GDP performance. The Fed’s dual objectives of price stability and full employment are better served by focusing on gross domestic product, or a revised inflation target says Saxon Trade expert, Manny Simon. ‘We would like to see the Fed pursuing a different target. Markets tend to eschew the Fed’s perspective on inflation, perceiving the 2% objective as unobtainable over the short-term. The Phillips Curve model may not be the best way to project US inflation prospects.’

Article by Taylor Wilman