On August 11, 2021, the greenback stretched its recent winning streak and struck multi-week highs against most other currencies. This was because of continued speculation that the release of an upbeat U.S. jobs report and hawkish remarks from several Fed officials last week would push the Federal Reserve to begin tightening its monetary policy.
Fed recent tapering
August 4 provided investors with an opportunity to gauge how much the market is influenced by monetary policy expectations. This is because it accounts for the largest percentage of fluctuation in the U.S. and European markets.
Greenback gains
On August 12, the dollar stayed at a four-month high against key rivals after dropping overnight as a slowing in consumer inflation dampened expectations for an earlier tightening of U.S. monetary policy.
The consumer price index gained 0.5 percent last month, matching economist expectations but falling short of the 0.9 percent increase in June.
In addition, inflation fell in some areas where Fed policymakers had predicted price increases would be transient, such as used vehicles.
A labour market recovery has become a precondition to phase out the Fed's asset-buying plan and increase interest rates.
At the same time, current inflationary pressures are largely viewed as temporary, though there has been discussion about how long such pressures can continue.
Boost in the U.S. economy
Increased inflation in the U.S. has already reached a level that could meet one leg of an essential test for the beginning of the rate increase, although the workforce has yet to improve.
Last year, the Fed reduced its standard overnight interest rate to almost zero and pledged to continue to purchase $120 billion in state bonds every month until sufficient progress is made towards its inflation and employment objectives.
This monetary assistance, combined with substantial fiscal assistance, aided in bringing the economy out of the crisis and putting it on a route to recovery.
The ADP report
According to an independent ADP report released on August 6, private-sector employment growth was just 330K, half of expected and lower than the previous month's numbers.
This job creation rate is worrying because over 6.5 million people are still jobless compared to pre-pandemic numbers, not to mention the normal increase of the job market throughout these 16 months.
The ADP statistics reduced the official non-farm payroll information expectations on Friday, boosting speculation that the Fed might not have to lessen its support.
On the other hand, the ISM Purchasing Manager Index saw a high score of 64.1 points for everybody, including an increased employment category. The figures show a preview of non-farm payrolls for Friday.
Tapering asset purchases
President Raphael Bostic of the Atlanta Federal Reserve Bank said that he anticipated that a bond purchase taper will begin in the fourth quarter. It can, though, begin sooner if its new scorching recovery pace remains on the labor market.
Moreover, Tom Barkin, President of the Fed, and Richmond Fed consider inflation has already attained its 2% target based on their assessments. This is one of two conditions that must be fulfilled before rate increases can be assessed.
Bostic and Barkin's statements point to a growing degree of focus as Fed officers debate how and when to cut buying assets on what they will do to achieve Fed's inflation target within the framework.
Bostic, who in late 2022 already clued the beginning rate rises, alluded, according to his estimates, to the five-year annual average for the core individual spending indicators or core PCE inflation, which amounted to 2% in May.
What about inflation?
Inflation has risen this year as the economy has reopened, and supply chain issues have made it harder for some businesses to meet increased demand.
President Joe Biden stated on August 11 that his administration is taking steps to remove bottlenecks that are jeopardizing the economic recovery and that he trusts the Fed to take whatever necessary steps to keep prices in check.
Last month, the President of the St. Louis Fed, James Bullard, indicated that the current inflation rate is significantly above the central bank's 2% target at 3.5% per annum using the Fed's preferred method. Thus, in his judgement, enough is required by the new central bank structure to make up for past poor inflation.
Jerome Powell, Fed President, has frequently maintained that the inflationary pressures he feels are temporary.
Still, some policymakers believe that stopping asset purchases will provide greater options to respond if inflation persists longer than expected.
Surrounding labor market
The Fed officials agreed to hold the rates at zero, under a new framework disclosed last year, until the full and inflationary markets achieve an average of 2% with an opportunity of slightly over 2% for some time.
Policymakers announced in December that they would keep buying government bonds at the present rate of $120 billion per month until there is a major progress toward the central bank's inflation and employment targets.
According to Bostic, the Fed has effectively met the pandemic's enhanced inflation target, with high inflation levels.
More progress in the labor market is still required, but that target might be reached after another month or two of solid job growth.
What to expect from the Feds?
The Fed's vice chairman, Richard Clarida, stated that upside risks to higher inflation, as well as his anticipation for a steady labor market recovery, would indicate an economy that could be ready for higher short-term interest rates in more than a year.
Clarida said he would be willing to support hiking rates in early 2023 if the jobless rate fell to 3.8 percent by the end of 2022. However, the increase in COVID cases by the Delta variant may nonetheless pose certain dangers to this prognosis.
With annual consumer inflation in the United States running at 5.4 percent, a Fed contingency plan must be in place if the economy continues to heat up. A near-million job gain in July non-farm payrolls announced on Friday demonstrates that the recovery's momentum remains strong.
It appears a little insane, though, that the Fed is still adding $120 billion a month to a balance sheet worth more than $8 trillion, especially given that housing prices in the United States are rising at the highest rate in more than 30 years.
Stronger July report
A better-than-expected July jobs report indicates that the economy may soon be able to run with less Federal Reserve help.
According to data issued on August 6 by the U.S. Bureau of Labor Statistics, there were 943,000 non-farm payroll gains last month, with the unemployment rate falling to 5.4 percent.
The economy is getting closer to pre-pandemic conditions. During the worst of the economic shutdown, employment fell by as much as 22.4 million. However, by July 2021, the economy appeared to be regaining over 17 million of the lost jobs.
The central bank is determined to keep its easy-money policies in place, as millions remain unemployed. Still, the solid July data may give some officials cause to begin reducing its asset buy program later this year.
As part of its quantitative easing policy, the Fed has absorbed around $120 billion per month in U.S's treasuries and agency mortgage-backed securities.
Fed Chairman Jerome Powell hinted that lowering the pace of those purchases may begin soon but gave no further hints as to when that might happen.
With inflation now exceeding the Fed's 2% objective, the central bank is weighing when to tighten policy as it monitors the labor market's recovery.
Feds are watching BoE
In its Quarterly Review on August 5, the Bank of England gave its forward guidance, as a small strengthening of monetary policy is likely to be warranted throughout the projected term.
It was like a precaution. Indeed, the Bank of England is the first major Central Bank to have a strategic stimulus reduction strategy that has parameters for stopping the flow of quantitative easing, if it can gradually taper the balance sheet, and even if it is purposely sold.
The BOE only takes its time, however. So Governor Andrew Bailey has created a shop to see others.
The others are fellow central bank heads preparing for their annual conference, which will be held in Jackson Hole, Wyoming, from August 26 to 28.
They are just as concerned as Bailey about how markets and economies react when forced to reduce their stimulus measures.
Fed Chair Jay Powell is one of them, with his eye on re-appointment for a second term, which the Biden administration is expected to announce in the fall.
Speculation of 2023
The Federal Reserve's number two official, Richard Clarida, stated on August 11 that if the U.S. economic recovery proceeds as expected, the central bank might begin its first post-COVID 19 rate hike in early 2023.
The vice-chairman stressed that policymakers would be driven by data-backed outcomes rather than forecasts across all economic variables monitored by the Fed.
According to Clarida, the recovery and expansion following the outbreak are unlike anything we've ever seen and staying humble in anticipating the future will help us.
Clarida's term expires on January 31, 2022, and it's unclear if the Biden administration will want to reappoint him by the time he expects to see the first-rate hikes.
Clarida was, nonetheless, a key architect of the federal bank's new monetary policy strategy. Following a nearly year-and-a-half review that began in 2019, the Fed announced in August of last year that it would begin allowing inflation to rise above its 2% target gradually.
Under these conditions, beginning policy normalization in 2023 would be perfectly compatible with our new flexible average inflation-targeting approach, Clarida said, referring to his inflation and unemployment estimates.
What does Morgan Stanley say?
Morgan Stanley analysts predict that the U.S. Federal Reserve will begin reducing its bond-buying program, which has pushed U.S. 10-year Treasury rates to their longest climbing streak in six months by the end of 2021.
They (the U.S. Fed) have decided on an inflation target. It is not the fear they are concerned about; rather, it is the labor market on which they are concentrating their efforts, remarked Ellen Zentner, Morgan Stanley's top U.S. economist.
We're starting to see an uptick in the labour supply. In this regard, September and October are critical because the benefits are about to expire.
Schools are reopening, and people are returning to work, so there will be an increase in labor supply, which will keep job numbers elevated, she said.
According to Zentner, by the end of the year, half of the employment lost because of COVID will be recovered. As a result of their progress with the labor market, the U.S. Federal Reserve may soon begin its tapering journey.
Can delta disturb taper talks?
Top economic officials are confronted with a fundamental question: Will the Delta variant keep the more than 6 million Americans out of work relative to pre-pandemic levels?
The Federal Reserve's policymakers, who are in charge of the central bank's economic policies, are keenly monitoring the impact of the rising case count as they consider a reduction in their easy-money policies.
Suppose individuals are concerned about the Delta variation. In that case, it may hinder part of the labor market recovery and drag our economic recovery, according to Minneapolis Fed President Neel Kashkari.
For the time being, the central bank is sticking to its aggressive monetary stimulus strategy, which includes near-zero interest rates and asset purchases that have pushed its balance sheet past the $8 trillion levels.
However, the Fed ponders a reduction in its asset purchase plan, acquiring around $120 billion per month in agency mortgage-backed securities and U.S. Treasuries. Last Wednesday, Fed Chairman Jerome Powell hinted that the central bank might begin tapering its so-called quantitative easing program in upcoming meetings.
This could be determined by how the economy grows in the next months. Powell stated that while the Delta surge will have serious health impacts, he is not concerned that it would significantly disrupt the recovery.
What we've seen, though, is that succeeding rounds of COVID over the last year and a half have tended to have fewer economic repercussions, Powell told reporters on July 28.
The impact on the forex market
It is self-evident that when the central bank decides to inject huge sums of liquidity into the system, it will impact all financial markets. In the instance of the forex market, the result was an oversupply.
When the Federal Reserve purchased large sums of bonds, it paid in cash, then poured into the financial system. As a result, the U.S. dollar became oversupplied.
As a result, in the early stages of the pandemic, the U.S. dollar rose because many investors flocked to it as a reserve currency.
However, the dollar fell in value during the next few months, particularly against currencies from developed markets such as the EUR, GBP, AUD, CHF, and JPY. This is due to the Federal Reserve's easing policies substantially outpacing those of other developed countries.
Why did the USD soar?
The rationale for such enormous USD pumping was to help the U.S. economy. To prevent the Covid-19 pandemic, the U.S. government imposed severe restrictions on businesses and individuals.
However, we have seen a significant comeback in dollar shorts during the last few months. This is because vaccination rates have increased, with over half of the U.S. population now fully immunized.
This has aided the federal and state governments in removing limitations across the country. The reopening is also reflected in the economic results, which have so far been good.
In 2013, a similar event occurred. In response to the 2008 financial crisis, the Federal Reserve began purchasing bonds and continued to do so for several years. This had lulled markets into complacency, as they expected extra liquidity to last for a lengthy period.
However, Ben Bernanke, then chair of the Federal Reserve, announced his intention to taper the purchases in 2013. Naturally, the markets were taken aback by this. As a result, the U.S. dollar rose sharply, causing practically all currency pairs to see a significant change in a few days!
What to look for?
There are two paths for the forex market out there. One is that the Federal Reserve continues to make these pronouncements while implementing the taper gradually. So in this instance, while there will be an initial significant market reaction, it will not last long.
The second scenario is that the Federal Reserve believes the purchases are causing more harm than benefit, particularly inflation. In that situation, the Federal Reserve's purchases might be drastically reduced, resulting in a major reversal. But, again, markets are bound to react violently in this instance, and prices will be impacted for a lengthy period.
These will be felt most sharply in emerging markets, which are the most vulnerable to risk-off measures like this. The previous taper had caused these currencies to drop by 20-30%, causing several countries to face a current account crisis.
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