Morning Brief – Calling the bluff

Calling the bluff

As expected, the Federal Reserve raised interest rates in the United States yesterday evening by a further 50 basis points. As a result of this policy adjustment, immediate target policy levels now stand at 4.25-4.5%. As also expected, the Fed pushed back fairly hard on the idea that it is ready to take its foot off the pedal with respect to monetary policy adjustment in its pursuit to tame inflation. Jay Powell went just about as far as he could reasonably go in order to sustain expectations of further policy tightening. The Chairman even acknowledged that it’s continued policy path could result in damage to the economy and even encourage a period of lower economic and labour market performance. The Chair definitely talked a strong game, however, the reason why the Dollar was able to secure a short-term gain was likely more down to the newly released dot plot.

The reason why the Fed attempted to push back on tapering expectations is fairly logical. The market had already been pricing in a degree of policy adjustment in the United States in the coming months. Expecting that the Fed will soon have to tame its upward policy adjustments and even begin to look at loosening to support growth and employment later in 2023, markets have encouraged two noticeable trends in asset prices. Firstly, a weaker US Dollar. Secondly, lower treasury yields which lower the cost of borrowing on related assets, dampening the central bank determined policy levels. Both of these two asset price themes, if sustained, would encourage inflation further and damage the Fed’s overall aim of killing severely above target price growth. However, Jay Powell’s strong words alone were unlikely to convince the market and as we saw in the hours after the decision, the Dollar returned to session lows versus both the Euro and British Pound.

The dot plot has and will continue to provide some support to the Dollar. This critical element of Dollar forecasting shows how members of the FOMC within the Reserve expect policy rates to evolve at particular points in time. Those rates showed upgraded forecasts versus the last observation with an end of 2023 and 2024 rate of 5.1% and 4.1% respectively: punchy. The market will continue to watch critical decisions on monetary policy from the ECB and the Bank of England today before any major adjustments in pricing. However, the Fed could just have done enough to stop or even reverse this latest cycle of Dollar weakness. The Dollar is still likely to correct lower next year, however, with a strong commitment to healthy hikes in Q1 of next year as demonstrated last night, the deterioration in the short-dated portion of the yield curve in the US could be arrested, drawing further demand back to the Dollar in the short run.

Discussion and Analysis by Charles Porter

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