U.S. Federal Reserve (Fed) Chair Janet Yellen and European Central Bank (ECB) President Mario Draghi both spoke recently at Jackson Hole, the annual gathering of central bankers and economists. Markets were on the lookout for hints as to the future course of monetary policy.
There were hopes that Ms. Yellen would provide guidance on the pace of policy normalization – specifically, interest-rate rises and a reduction in the size of the Fed balance sheet. Market observers were also looking to Mr. Draghi for some detail on the scale and pace of the ECB’s approach to tapering its bond purchasing program. In the event, Ms. Yellen chose to focus on financial regulation and Mr. Draghi on global trade. Both avoided providing meaningful signals on monetary policy.
However, one development that is sure to influence the deliberations of both central bankers in the weeks and months ahead is the recent performance of their respective currencies; the trade-weighted dollar has depreciated significantly this year, while the euro has appreciated by close to 10%.
At the beginning of 2017, many market commentators were predicting that the dollar would rise in value. These forecasts were predicated on expectations that the incoming Trump administration would move forward with plans to reform America’s taxation system and implement a big program of infrastructure expenditure. However, President Trump’s plans have been stymied by an inability to successfully advance the necessary legislation through Congress.
In itself, the currency weakness is not necessarily a bad thing. After all, dollar depreciation should support U.S. growth by boosting exports, and put upward pressure on import prices that feed into higher inflation. At least that’s the theory. But as obvious as this might seem, the link between the strength (or otherwise) of the currency and its effect on the price of imports is far less clear-cut than this.
To illustrate: from mid-2014 to the end of 2016, the nominal trade-weighted value of the dollar strengthened by 25%. Accordingly, one might have expected dollar strength to exert significant downward pressure on import prices and core inflation. And yet, over this period, import prices were remarkably resilient.
Since the end of February 2017, the dollar index – a measure of its strength against a basket of six developed-market peers – has fallen by 9.4%. In the circumstances, it seems reasonable to anticipate only a modest boost to future inflation from recent dollar weakness.
While…recent dollar weakness might affect its timing, the impetus towards monetary policy normalization is still there.
Nevertheless, this still supports the argument in favor of additional monetary tightening. While, at the margin, recent dollar weakness might affect its timing, the impetus towards monetary policy normalization is still there.
No clear signals from Draghi
Turning to the Eurozone, Mr. Draghi passed up the opportunity at Jackson Hole to deliver a clear signal, although this is fairly typical. Both the ECB’s president and its Governing Council have tended to shy away from setting expectations for the timing of an exit from quantitative easing (QE).
On the face of it, the recent appreciation of the euro – and its negative ramifications for inflation – puts the assumed exit from QE at risk. However, an improvement in growth prospects – which might be a primary reason for the euro’s recent strength – could act as a counterbalance to the drag on inflation.
On balance, we still expect balance-sheet normalization and another interest-rate rise in the U.S. this year. Meanwhile, we expect the ECB to trim - not taper - its asset purchases later this year, but to leave interest rates on hold for the foreseeable future.