Extended Easy Fed Policy Keeps USD Under Pressure

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. 

The outcome of last week's long-awaited FOMC event confirmed the Fed's continued bias toward an accommodative policy. The verbiage of the Fed statement was little changed and quite close to the market expectations that had developed in the weeks leading to the meeting. But Chairman Bernanke's inaugural press briefing hinted that the view of the strong dovish majority, led by Chairman Bernanke, prevailed. The statement continued to downplay upside risks to inflation and downside risks to growth.

In reaction, the USD declined dramatically, providing evidence that extended easy Fed policy will continue to put material pressure on the USD. The USD suffered its worst monthly performance since October 2010 sinking to multi-year lows against most currencies. The dollar index rolled to three-year lows near 73.0. In contrast, stock markets soared on the prospect of a Fed on hold for the rest of this year while Treasury yields dropped to their lows over the year.

Despite rhetoric from the hawks in the inter-meeting period, the statement confirmed that there was no formal dissent to unchanged easy policy. The Fed seems to be content with its wait-and-see attitude towards inflation and holds the view that the economy is not overheating, thus there is no rush to tightening. Against that backdrop, a few elements of the FOMC statement and Bernanke's press conference had surprised the market to such extent that the USD was driven down to cyclical lows. These elements are:

Economy - The economic recovery was downgraded, as market expected, from "firmer footing" back to "moderate pace" according to the statement, while "inflation has picked up in recent months" was added to preface that underlying inflation trends remaining "subdued."

Inflation - An upgrade of the degree of inflation concern that investors have been looking for did not emerge in either the statement or Bernanke's press conference. Only very subtle changes were made to this section of the statement, as commodity-driven inflation is seen pushing up inflation "in recent months" vs. "currently," and importantly this is still seen as "transitory." Rising commodity prices driving inflation higher were still characterized as "transitory." The Fed seems to have expanded its comfort zone regarding how core inflation is evolving. Bernanke also dismissed USD weakness as a factor driving up commodity prices.

QE2 - Though QE2 was forecast to be wrapped up as scheduled "by the end of the current quarter," Bernanke also indicated that the Fed would probably maintain the size of its balance sheet in the months to come, rather than allow some natural shrinkage by not investing in maturing debt. The Fed is "prepared" to adjust those holdings now, whereas it previously said it "will adjust the program as needed." Thus, the end of QE2 would be the end of additional easing, but not the beginning of tightening. Bernanke also concluded the QE2 was a success, using gains in stock and credit prices as the measure of success.

Strong USD Policy - The Chairman's comments on the USD were unconvincing. He said repeatedly that Fed policy aims to facilitate the conditions for a strong and stable USD in the medium term. Yet the Chairman and other key Fed speakers have continuously pushed the emerging markets to allow flexibility in their exchange rates, or a weaker USD, to correct trade imbalance. An article in last week's Wall Street Journal also reported that U.S. officials are unfazed by the USD's decline. It cited that it appears no policy is in the work to the USD's advantage while some current U.S. policies are some of the factors that drive the USD lower.

The above revelations in the wake of the latest FOMC meeting reinforced the view that any shift in the Fed policy will happen slowly and is contingent on upcoming events. The Fed chief is willing to let the dice roll on QE2 in the face of both increasing inflation risk and a sub-par recovery. On the contrary, other central banks are expected to tighten sooner. The European Central Bank is expected to hike in June/July, given the probability of substantial upward revisions to the next batch of euro zone inflation data. From the market perspective, with the prolonged easy Fed policy, there is little to discourage flows into emerging markets and the ongoing reserve diversification that have steadily weakened USD versus G10 as well as EM currencies. Current U.S. easy monetary policies coupled with recent weak U.S. data will work against the USD in the coming months.