The Fed meeting comes as an excuse to take a slightly warmer look at the pushed-to-defensive dollar. The EUR/USD pair dives towards the 1.20 mark. A break lower here could open further downside.
Fed policy stays the same, but attitudes change
The Federal Reserve did not change key policy parameters. Interest rates remain near zero, and aggressive asset purchases will continue at a pace of 120 billion USD per month. The rate on excess reserves (IOER) was raised (by 5 bps from 10 to 15 basis points), but this is a technical move forced by the recent wave of excess liquidity in the money market. The narrative that both the labour market problems and the rise in inflation to 5% are temporary events is also still being maintained. Once the disturbances related to the pandemic and the reopening of the economy subside, the recovery in the number of jobs should accelerate, and the inflation rate should decline significantly.
In the latter aspect, the responsibility is continuously being pushed down to such goods as used cars, airline tickets and hotel accommodation rates. According to policymakers, the economy is still not in a place to start reducing the scale of asset purchases, but discussions have begun on a strategy for trimming the financial help. Such a decision is to be communicated well in advance. It was also declared that it would be a methodical, gradual and transparent process for market participants. Nevertheless, the overtone of the meeting was perceived as an encouragement to buy the dollar and sell-off US treasury bonds. Wall Street also reacted negatively.
The dollar finds arguments in Fed forecasts
This was determined by new projections derived from the beliefs of individual policymakers (regardless of whether they have voting power in a given year). First of all, thirteen out of eighteen FOMC members believe that it would be ideal to start raising rates in 2023. This is a marked increase from March when seven of them held this view. As a result, the median expectation of the desired ceiling for the cost of money has shifted sharply and suggests two hikes in 2023. The projections for economic growth have also risen: GDP growth is expected to reach a record 7% this year. The projected inflation path has also risen. This year, the Fed's preferred measure of price pressures (the PCE Core index) is expected to increase by 3%, and in the following two years to be at a level roughly in line with the Federal Reserve's target (in both cases, the median estimate of policymakers is 2.1%).
The market interpreted the forecasts as a sign of growing concern on the part of Fed representatives that the price growth may be more persistent than previously assumed. It should be expected that in the following days, the negative attitude towards the US currency will fade. The timing of the real turnaround in Fed policy will be determined by the incoming economic data and the pace of job creation. The end of asset purchases itself seems to be well digested by the markets. We expect such a decision to be communicated at the turn of 2021 and 2022. It is important to keep in mind that the current Fed decision-makers are relatively mild-mannered. We stand by our opinion that next year and the approaching date of the first rate hike in the US will allow for creating a more lasting positive trend for the dollar.