With the FOMC Statement and the press conference behind us, the U.S. Dollar is on the defensive. Chairman Powell’s first presser turned out to be an exciting one.
Nervous at first, hesitating a bit, Powell managed to pull up an excellent performance, not only to answer difficult questions but doing it with style, clarity, and personality.
The monetary policy decision was well-known ahead of the event. Market participants priced in a rate hike with a probability of one hundred percent.
No surprises there, as the Fed delivered the rate hike. However, the focus shifted quickly to the number of future rate hikes the dot plot suggested.
The debate was if the Fed signals four rate hikes this year or only three. In the end, the plot showed three rate hikes on the table, at least judging from the median value.
However, there’s a catch here, and Fed’s Powell was the first one to warn about this: those plots are nothing but a forecast.
Who can forecast the economy over the next three years? In other words, like any forecast, it can change dramatically if the economy doesn’t confirm.
Monetary Policy Challenges
With the current rate hike, the Fed delivered, the federal funds rate sits at 1.75%. This is in sharp contrast with anything that happens in the rest of the world, at least on capitalistic economies that rival the United States.
Yet, the dollar tumbled. Despite the rate hike, and the prospect of other hikes this 2018 (that will push the rate over 2%), the dollar didn’t gain, but lost value.
As a trader, it is difficult to argue with the tape. Or, with the price action.
When logic doesn’t make sense, one needs to revert to the fundamental economic principles.
In the end, it all comes down to inflation and interest rate. A typical central bank’s reaction is to raise rates when inflation picks up, to anchor inflation expectations.
After inflation reaches the target (below or close to two percent), the central banks (in this case, the Fed) will face a tough choice. Pushing rates even higher to further steam inflation, or stay put and see what inflation expectations will look like.
In other words, being proactive or risking falling behind the curve.
But traders, in the last years, seem to be forgotten the big question in any inflation/interest rate relationship. At what point, higher inflation fails to translate into a higher dollar?
So far, if inflation sits below two percent, traders buy a currency on expectations that the Fed raise rates. So, it did.
But how about inflation still pushing higher? How about, after all these hikes, and the ones to come, inflation will again push higher? That’s the moment when a currency depreciates, no matter how many rate hikes will follow, as market participants will stop focusing on the level of interest rate, but on the value of the dollar.
Also published on Medium.