FX | Monetary Policy & Inflation | US
Average Inflation Targeting (AIT) could be a net negative for the dollar as other global central banks appear unable or unwilling to follow the Fed.
The G20 FX Covenant
Ever since the G20 in 2013 committed to ‘not target our exchange rates for competitive purposes’, global central banks have by and large refrained from open foreign exchange intervention. The G20 FX covenant has been maintained under the Trump presidency, which has preferred to put pressure on individual countries rather than engage in outright FX intervention.
Yet exchange rates are never far from central bankers’ minds. Whenever they get asked how the exchange rate factors into their policy decision, their stock-in-trade answer is that while, per the G20 covenant, they do not target exchange rates, those are important drivers of inflation and of the output gap.
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Average Inflation Targeting (AIT) could be a net negative for the dollar as other global central banks appear unable or unwilling to follow the Fed.
The G20 FX Covenant
Ever since the G20 in 2013 committed to ‘not target our exchange rates for competitive purposes’, global central banks have by and large refrained from open foreign exchange intervention. The G20 FX covenant has been maintained under the Trump presidency, which has preferred to put pressure on individual countries rather than engage in outright FX intervention.
Yet exchange rates are never far from central bankers’ minds. Whenever they get asked how the exchange rate factors into their policy decision, their stock-in-trade answer is that while, per the G20 covenant, they do not target exchange rates, those are important drivers of inflation and of the output gap.
This analytically correct answer highlights the ambiguity of the G20 covenant: domestic conditions are meant to drive monetary policy stances; but, given the carefully calculated ambiguity of central bankers, in practice it can be difficult to question their motivations. For instance, a current account surplus can reflect weak economic growth as well as an undervalued currency.
Global Demand Shortage Makes Currency Weakness Desirable
In a global economy with wide open output gaps, a weaker exchange rate is better than a stronger one. No country knows this better than the US: the US exited the GFC faster and in better shape than most other economies. As a result, the Fed was able to start normalizing its policy well ahead of other central banks. This saw the dollar appreciate by 30% in real terms between mid-2014 and end-2016. In a 2015 speech, Stanley Fischer, the former Fed vice-chair, estimated that a 10% real appreciation of the dollar cost US growth 1½ ppt over three years.
This time around, markets are not pricing lift-off any time soon at any global central bank. Nevertheless, in a global environment of demand scarcity, central banks are likely to keep watch over their shoulders for which of their neighbours is most aggressive in loosening monetary policy.
The Fed AIT Includes Less Responsiveness to Low Unemployment
Enter Average Inflation Targeting, formally introduced by Chair Powell at the Jackson Hole symposium last week. Since then there have been repeated attempts by market participants and medias to get the Fed to specify how high they would be prepared to let inflation overshoot, so far with limited success.
But perhaps what is more important than the extent of inflation overshoot (and, anyway, we are unlikely to get clarity from the Fed) is the change in the Fed reaction function as part of the move to AIT. In the past the Fed, a strong believer in the Phillips curve, would start policy normalization once unemployment fell below a threshold.
From now on, however, as explained by Vice-Chair Clarida, ‘a low unemployment rate by itself will not, under our new framework, be a sufficient trigger for policy action’. In other words, even if spare capacity disappears, the Fed will wait until it sees the white in the eyes of inflation before hiking. The Fed is committing itself in advance to remain dovish and in that sense AIT is dollar negative, provided other global central banks do not follow suit.
Global Central Banks Unlikely to Follow Fed
Global central banks are unlikely to follow the Fed, mostly because, in practice, they have already become more reactive to low unemployment. The ECB in 2005 normalized policy proactively, when unemployment was close to 9% and two years away from its trough.
Post GFC, however, the ECB and BoJ have become less responsive to low unemployment. The ECB started easing in September 2019, when unemployment was still falling. Since the outset of Abenomics in 2013, the BoJ has ignored unemployment and instead has been chasing an inflation target that has so far proven elusive.
In 2017 the BoE, by contrast, stopped expanding its balance sheet and hiked in October, ahead of unemployment reaching a low in Q1 2019. Of the three central banks, the BoE has the more room to follow the Fed but seems unlikely to do so because in real, trade weighted terms, the pound remains close to its post-GFC lows.
Overall, the Fed move to AIT and a reactive policy response to low unemployment seem a net negative for the dollar. ECB and BoJ have already turned so dovish and unresponsive to unemployment that they will be unable to match the Fed. The BoE could potentially follow the Fed but seems unlikely to do so in the near future.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)