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Fed Dents the Dollar

- 'Hawkish' Fed tipped to raise interest rates two more times in 2018

- But Dollar sharply lower

- Markets might have simply wanted even more rate rises signalled

- Inflation forecasts remain soft, could be behind Dollar's reaction

Powell Fed

Above: Chairman of the US Federal Reserve, Jerome Powell © The White House

The US Dollar fell across the board after the US Federal Reserve raised interest rates but signalled they were in no rush to hasten the pace at which they raise interest rates in the future.

The March 21 Federal Open Market Committee (FOMC) meeting produced the expected 0.25% interest rate increase but the policy guidance on future interest rate moves was modestly more ‘hawkish’ than predicted.

"The immediate market reaction has been mixed. US Treasury bond yields have risen, with 10-year yields rising by more than shorter dated paper," says Rhys Herbert, Senior Economist with Lloyds Bank Commercial Banking. "However, the US Dollar has fallen against both Sterling and the Euro."

At one stage the Pound-to-Dollar exchange rate was quoted 1.0% higher following the event at 1.4150 with a new multi-week best at 1.4170 being achieved today. The Euro-to-Dollar exchange rate was quoted 0.78% higher at 1.2344 in the wake of the event.

On an unanimous vote, the FOMC opted to raise the key policy rate by 0.25%, taking the top end of the target band to 1.75% in an outcome that was no surprise to markets which were pricing the event at an almost 100% probability.

This is the sixth increase in the current rate raising cycle which started back in December 2015.

The accompanying statement continues to describe the pace of tightening as “gradual” and that “further” increases are likely.

"As today’s rate increase was already so widely expected, markets were probably more interested in the FOMC’s guidance on its policy actions for the rest of this year and further out, which turned out to be a touch more ‘hawkish’ than before," says Herbert.

The much-watched ‘dot plot’ graph of FOMC participants’ interest rate expectations - contained in the latest set of economic forecasts - shows that the majority think this policy will require two further interest rate rises in 2018:

dot plot march 21 2018

The above compares to the previous graph released in December:

December Dot plots

"The Committee expects to continue to raise interest rates toward, and probably beyond, what it regards as the long-term equilibrium rate of 2.75%," notes Herbert.

So why did the Dollar fall in response to what, on paper at least, is a classic pro-Dollar FOMC event?

Kathy Lien, a currency market commentator with BK Asset Management notes that the dot plot graph signalling only 2 more hikes in 2018 will be a disappointment: "Investors were hoping that the dot plot would shift to 4 hikes this year instead of 3 and when that did not happen they were sorely disappointed. While the Fed expects to tighten 3 times in 2019 up from 2, investors are focused primarily on the year ahead as they see the slower tightening cycle as a need for patience."

The problem appears to be that markets were wanting an even more aggressive path for interest rates, "the USD has eased, markets evidently bracing for a more hawkish pivot, especially in the 2018 dots - they drifted higher, but not enough to lift the median beyond the existing 3 hikes," says Richard Franulovich with Westpac Bank in Sydney.

Markets are already biased to selling Dollars and the Fed event clearly did not provide the kind of triggers required to snap this trend. "The USD reaction suggests markets remain fundamentally biased towards selling the USD outside of periods of significant risk aversion," says Valentin Marinov, an analyst with Crédit Agricole.

Richard Perry, an analyst with Hantec Markets reckons another issue lies with the Fed's inflation expectations for 2019 and 2020 were only revised up by 0.1% to 2.1% for each year.

"This could be why the market is reacting as it is," says Perry, pointing out that the inflation expectations don't mirror the hawkish projections for future interest rate rises.

Dollar bulls who were hoping for a more agressive slope of interest rate rises clearly don't have the backing of the inflation projections to maintain their stance.

"There is an interesting look to the Fed member projections for inflation and unemployment which suggest the FOMC remains stumped as to why inflation is not suitably increasing," says Perry.

Lien agrees:

"According to the FOMC statement, the Fed believes that the economic outlook strengthened in recent months and inflation will move up, stabilizing around 2%. However in his press conference, Fed Chair Powell said pressures on inflation have been very gradual and they don't get a sense from data that inflation is about to accelerate."

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Powell's First Outing Rings in Some (Small) Changes

The meeting was also notable as the first for new Fed Chairman Jerome Powell who in his press conference sounded upbeat about the economy.

He noted that the Fed is trying to take the “middle ground” on rates, confirmed that he wanted to avoid inflation running persistently below target but also noted potential risks of raising rates too slowly which echoes the stance of his predecessor Janet Yellen.

Indeed, Powell has always been touted as the continuity candidate and this might be another source of disappointment. "The Fed Chair also wants to see productivity increase and wages rise. They have been surprised at how modest wage gains have been given the overall strength of the labor market. Also, they are leery about the impact of tax cuts and worried that trade tensions could pose a risk to their outlook," says Lien.

There were also some significant changes to the press statement compared to the previous meeting in January.

Most notable was the introduction of a new, more upbeat reading on the economy that said: “The economic outlook has strengthened in recent months”.

"The introduction of this amendment is particularly significant as some recent data, notably retail sales, have surprised on the downside," says Herbert. "The change is consistent with the recent comments from Fed Chairman Powell that the headwinds holding back growth are turning into tailwinds."

It has probably been prompted in part by the more expansionary fiscal policy introduced by the Trump administration, although other factors including stronger global economic growth may also have played a role.

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