The July meeting of the US Federal Reserve concluded last week as expected, with no changes to monetary policy. The Central Bank maintained the target range for the federal funds rate at 1%-1.25%.
The text of the statement contained no major surprises. Its description of the economy’s performance was very similar to the June version, stating that the labour market has continued to strengthen and that economic activity has been rising moderately.
There was a change to the Fed’s characterisation of the current inflationary environment.
The Fed acknowledged the recent softness in inflation, observing that “overall inflation and measures — excluding food and energy — have declined and are running below 2%.”
However, the Fed did not alter its view on the inflation outlook.
In terms of the economic outlook, the Fed continues to hold the view that the near-term risks for the US economy are roughly balanced.
It expects the economy to grow at a “moderate pace”. The official second quarter GDP data, also published last week, were consistent with this view, showing the economy grew at a 2.6% annualised rate.
The most recent set of interest rate projections from the Fed were released at its June meeting. The Central Bank is projecting the federal funds rate to be near 3% by the end of 2019.
The market, however, remains sceptical about the extent of rate hikes from the Fed. Current futures pricing suggest that the market is looking for rates to rise to around 1.75% by the end of 2019.
Overall, the July Fed meeting statement shows that it remains comfortable with, and intends to continue on its tightening path.
It also stated that it expects to begin implementing a reduction in the size of its balance sheet, which had been increased substantially by its QE purchases, “relatively soon”.
This suggests that we could get an announcement in this regard in September.
Meanwhile, if the economy evolves as per Fed expectations over the coming months, its final projected rate hike for 2017 may occur in December, something which the market has not fully priced in.
In terms of market reaction, the dollar weakened in the aftermath of the meeting, adding to its recent softer tone, with dollar watchers appearing to focus in on the Fed’s change to its description of the current inflation backdrop.
This has reinforced the markets less hawkish expectations of Fed policy tightening.
Indeed, it has been a tough summer so far for the dollar. The softer tone to the currency that started to set in over the first half of the year has gathered further momentum over the last two months.
Increasing uncertainty over the ability of the Trump administration to implement any sort of meaningful fiscal stimulus has also played a key role in the wind being taken out of the dollar’s sails.
Since the start of June, the currency has fallen in the region of 2%-4% against a raft of global currencies, including the euro, sterling and the Canadian, Australian and New Zealand dollars.
In level terms, this is reflected in EUR/USD hitting a two-year high last week above $1.17 and GBP/USD trading up near $1.31, while the dollar index fell to a one-year low.
For the dollar to regain its mojo, it will likely need both monetary and fiscal policy to play a role.
However, the prospect of a near-term fiscal stimulus from the Trump administration has greatly diminished, while it could be well into next year before it becomes clear if the market is underestimating the extent of Fed tightening.
Thus, the dollar could remain on the back foot over the coming months, with the EUR/USD pair in a $1.15-1.20 range.
John Fahey is senior economist at AIB
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