Scaling back by the Fed will be keenly watched

The pace of growth in the US economy has generally slowed in recent quarters, though picking up slightly in Q2.

This slowdown is partly due to a tightening of fiscal policy, which it is estimated will depress GDP by some 1%-1.5% in 2013.

However, underlying private sector demand is quite strong in the US, helped by low interest rates, strong corporate balance sheets, a recovering labour market and pent-up demand for housing and durables. Deleveraging is also quite well advanced in the US. The expectation is that, after subdued growth in H1 2013, the pace of US activity will accelerate later this year and in 2014 as the fiscal tightening abates.

Against this background, the Federal Reserve has kept its key interest rate at the historically low target range of 0%-0.25% since Dec 2008.

The Fed has indicated it will keep interest rates at close to zero for at least as long as the unemployment rate remains above 6.5% and medium-term inflation remains at or below 2.5%. With the jobless rate currently around 7.5%, any interest rate hikes are a long way off.

The Fed has also engaged in an aggressive QE (Quantitative Easing or asset purchases) programme since last autumn, with total asset purchases amounting to $85bn per month.

Following the FOMC meeting in mid-June, the Fed chairman, Ben Bernanke, said that the Fed was likely to start scaling back on QE before the end of the year.

The Fed has stressed, though, that this is dependant on the continued improvement of key economic indicators. In an effort to minimise the impact on markets of its QE tapering plans, the Fed has emphasised that policy will remain very accommodative after QE is brought to an end, indicating that interest rates will remain low for a prolonged time.

From a currency viewpoint, the US dollar has been a strong currency during the past couple of years, rising by over 10% on a trade-weighted basis against the other majors since mid-2011. This is despite the further marked easing of Fed policy since last autumn. However, the dollar did lose some ground over the summer against the yen, sterling and the euro. This may be partly due to the fact that, while the Fed has indicated that it is likely to wind-down its QE programme over the next year, it has put great emphasis on the fact that interest rates are set to remain exceptionally low for a prolonged period of time. Furthermore, the slower pace of US growth in recent quarters, highlights the need for interest rate policy to remain accommodative.

On a short-term horizon, speculation about when the Fed will begin to taper its QE programme will remain a dominant factor for the dollar. Market expectations are for this tapering to commence in September. The release last week of the minutes from the Fed’s July FOMC meeting did little to alter expectations around September tapering.

However, given the data dependency of tapering, some key releases over the coming weeks, including payroll data and the ISM surveys, will be closely watched by the market, and could result in the dollar remaining somewhat listless in the near term.

From a medium-term perspective, if the US recovery regains momentum later this year and in 2014, and QE starts to be withdrawn, this could become a key influence on forex markets. It would highlight that the Fed is likely to be the first major central bank to begin increasing interest rates, which may help the dollar.

Overall, then, while the dollar may remain somewhat subdued in the near term, it could make gains over the medium-term if US growth picks up to more robust levels and the labour market strengthens.