The Federal Reserve Act requires the Federal Reserve Board to submit written reports to Congress containing discussions of “the conduct of monetary policy and economic developments and prospects for the future.” This report–called the Monetary Policy Report–is submitted semiannually (in February and July) to the Senate Committee on Banking, Housing, and Urban Affairs and to the House Committee on Financial Services, along with testimony from the Federal Reserve Board Chair.
On 24 February US Federal Reserve (Fed) Chair Janet Yellen gave this well-anticipated testimony to Congress. Yellen gave a balanced assessment of the economy and inflation, indicating that the Fed is still on course to start raising rates in June 2015. The key achievement by Yellen in this testimony was to skillfully prepare markets to allow the Fed to drop its constraining language surrounding the word “patient” from Federal Open Market Committee (FOMC) minutes at the next meeting in March, thereby undercutting a potential “knee-jerk” reaction by markets to the removal of this word.
On another front, Greece cleared the first hurdle toward the extension of financing by agreeing to conditions imposed by the EU and the European Central Bank (ECB) to stay in a program of stabilization. The arduous process of resolving Greece’s financing issues for good remains daunting and has only been postponed by months, but the risk of a systemic event for markets in the near term has been lessened dramatically.
With the US in solid recovery mode, fears of Fed tightening less prominent after Yellen’s testimony, easing now in the pipeline for the ECB and other central banks, a postponement of “a day of reckoning” for Greek finances, low inflation worldwide, and an upcoming boost for consumers from low oil prices still expected, a period ahead of global growth resembling a “sweet spot” and higher risk-appetite in markets would not be surprising.
After a period of consolidation of about a month, the US dollar appears set to resume its uptrend as the divergence in monetary policy between the US and most other central banks in G10 is now striking: every G10 country has either been in an easing mode for some time or has eased in a surprise recent move, except for the US and the UK. Meanwhile, the Federal Reserve remains on a path to initiate its first increase in interest rates since the summer of 2006, while the ECB is just embarking on a program of quantitative easing (QE) in March 2015. A number of major continental European countries now have negative government bond yields for maturities under five years (e.g. German Bunds yield -0.1%, while US five-year Treasuries yield 1.50%). Under the circumstances, it is not surprising that the US dollar should appreciate further.
The divergent monetary stance of the US and countries in Continental Europe remains fundamentally based on the divergent economic and inflation prospects of the two regions. The US economy continues to show steady improvement, while the Eurozone as a whole continues to lag and stagnate. To be sure, the outlook for Europe may now be improving somewhat as a result of lower oil prices, the strengthening recovery in the US, and a lower value of the euro. The inflation outlook also remains similarly divergent in the US and Europe. Low oil prices feed into low inflation expectations more strongly in Europe than in the US and encourage the pursuit of non-conventional monetary policies such as negative interest rates and QE, whereas low oil prices are viewed as a windfall boost for consumers in the US, solidifying the economic outlook further for the second half of 2015 in the US.
As we look back on developments since the start of 2015, currencies, after a few years of frustratingly low volatility due to financial repression by central banks, are now playing their traditional role again as a release valve for macro-economic imbalances. A weakening euro is one of the main transmission mechanisms that would buttress inflation expectations and economic prospects in much of the Eurozone. The range for the Bank of England Calculated Effective Exchange Rate for the euro, from a high of 97.68 on March 12, 2014 to a low of 92.45 on October 1, 2014, was about 5.5% of the average level of 95.25 for this euro exchange rate – a very narrow annual range by historical standards, and one that certainly did not properly reflect the building macro-imbalances in the Eurozone. So far in 2015, the range has been at 7.2% of the average level of this euro exchange rate –a higher range than the full year of 2014, but still well below the typical average range of 8.9% since the inception of the euro in January 1999, more than 16 years ago. The highest volatility years since the inception of the euro were the first two years of 1999 and 2000, at 13.6% and 12.5% respectively, and 2008 and 2010, at 12.1% and 13.5% respectively. After the recent two years of a narrow range of 6.9% and 5.5% in 2013 and 2014, respectively, we would expect 2015 to show a range in excess of 13% again. With a euro high versus the US dollar of US$1.21/€ in early 2015, we would therefore project that a low around US$1.05/€—13% below the January high—would be a reasonably conservative target given the macro-imbalances implicit in the current divergences described earlier. At that level of US$1.05/€, the euro would be modestly below its purchasing power parity level, a necessary condition to boost European economic prospects after many years of a severe euro overvaluation.