Dollar Affected by Diverging Monetary Policy Stances

November 2, 2015

Quite a few central banks will be holding interest rate policy meetings this week.  These include the Reserve Bank of Australia, which also releases a new quarterly policy statement and the Bank of England, whose meeting coincides with its quarterly Inflation Report.  The list also includes central banks in Iceland, Thailand, Poland, Norway, Malaysia, the Czech Republic, and Romania.  In a few countries, such as Hong Kong and Singapore, domestic interest rate policy is subordinated to an exchange rate target in an explicitly mechanistic way .  Monetary authorities in some other central banks have expanded the role of currency market intervention (buying or selling one’s currency against another) from the conventional justification of countering disorderly market conditions to influencing a currency relationship’s level and ensuring that such is consistent with economic fundamentals and that it promotes other policy goals.  Switzerland, China, the Czech Republic and Denmark fall into this category.  Even where no exchange rate target exists, currency movements are not ignored because sharp currency changes invariably affect the outlook for growth, inflation and expected inflation. 

Most central bank meetings since mid-October ended without an interest rate change.  Such a decision happened in Indonesia, Mexico, South Korea, Peru, Hungary, Brazil, the ECB, the Federal Reserve, Japan, Canada, Russia, Egypt, New Zealand, Israel and Sweden.  Monetary policies were eased in Singapore, China, and Serbia, and the Central Bank of Chile tightened.  Within this group, the Fed, ECB and BOJ bear special scrutiny, not just because of the high visibility of the euro/dollar, dollar/yen, and euro/yen.  In addition, their monetary stances are not synchronized, and bank officials view potential currency changes differently.

Fed officials do not want investors to give abandon the view that an initial interest rate hike will occur sooner rather than later.  Authorities at other central banks, which pursued unconventional quantitative stimulus, have found it very difficult to implement exit policies even when they were predisposed to policy normalization.  It’s to the advantage of Fed officials that investors not extrapolate those experiences to what will ensue as the federal funds rate is lifted.  The Fed’s October 28th FOMC statement is unexpectedly specific, asserting in paragraph three, “In determining whether it will be appropriate to raise the target range at its next meeting,…”  By doing so, Fed officials imply that a rate hike in 2015 is indeed possible even though markets at the time had all but given up on a December tightening.  The drag on U.S. third-quarter growth from net foreign demand was trivial at only 0.03 percentage points, indicating that dollar appreciation hasn’t thus far exerted a cumulating headwind on the U.S. recovery’s ability to persevere.

The tone of ECB Draghi’s press conference on October 22 was quite dovish, leaving the strong impression that a package of stimulatory measures is likely to be unveiled after the Governing Council’s December meeting.   Here are some of the clues:

  • The text reads, “the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis. In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available.”
  • “There are risks stemming from the economic outlook and from financial and commodity market developments which could further slow down the gradual increase in inflation rates towards levels closer to 2%.”
  • Answering a question at the press conference, Draghi noted “the Governing Council has tasked the relevant committees to work on different monetary policy instruments that could potentially be used, to examine the pros and cons of different instruments. In other words, if one had to summarise what was the attitude or the stance of the Governing Council discussion today, one would say it was not “wait and see”, but it was “work and assess”.”
  • In discussing expected inflation, Draghi added, “we see some downside risk as far as this picture is concerned. And the downside risks come from a continuing high output gap, from the possible further fall in oil prices, from the fact that the nominal effective exchange rate has appreciated in the last three or four months, if I’m not mistaken, by almost 6%, and, finally, from the fact that we continue to observe a high degree of correlation between headline inflation and medium-term inflation expectations, which means a high degree of correlation between oil prices and inflation expectations. This is a risk because it could lead to a de-anchoring of inflation expectations. We are not saying that these risks are materializing, but they are present and as I observed in the course of the last meeting these risks have gone up, and we want to be vigilant.”  Under former ECB President Trichet, use of the word vigilant was code for signaling a policy change at the following Council meeting.

One sees above that while the ECB has no target for the euro and no intention of adopting such, officials were concerned back in October with erosion of the euro’s prior slide, which then was perceived as a possible obstacle to inflation rising to its target of below but close to 2% as soon as hoped.  The rhetoric of Draghi to communicate that concern in fact helped the dollar to recover some 3% against the common European currency over the past three weeks.

Many investors were hoping for the Bank of Japan to augment its monetary stimulus on October 30, just as had been done a year earlier.  The BOJ Board in this scheduled full review of the outlook for Japanese growth and inflation pushed back its projection on the timing for a likely return to the 2% core inflation target by a half year, suggesting that such will not happen until at a year from now and possibly not for another 18 months.  Economic growth has not been as firm as assumed.  External factors are blamed, but an important result has been the failure of wage growth to accelerate in tandem with non-energy consumer prices.  Here, Japanese officials draw a different inference than their ECB counterparts.  If the yen were to fall sharply as a result of augmented quantitative stimulus, import prices would increase, real household disposable income would be squeezed by higher prices but not higher wages, and consumption could falter.  So BOJ officials seem more downside risks to additional monetary stimulus than their ECB counterparts, and they are more ambivalent about additional depreciation of their own currency.  Picking up on these cues, investor behavior over the past two weeks did not allow the dollar to rise nearly as much against the yen as it did versus the euro. 

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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