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Bernanke’s Openness to QE3 and Fed’s 2014 Low Rate Pledge Kills the Dollar

Last updated 1/25/2012 3:55 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

By Kathy Lien, Director of Currency Research at GFT

The Federal Reserve’s decision to extend their low rates pledge to 2014 drove the dollar sharply lower against the euro, British pound, Japanese Yen and other currencies.  The greenback’s earlier gains were completely erased with the EUR/USD rising to its highest level year to date.  Everyone expected the Fed to be dovish but few anticipated enough consensus within the central bank for them to push out their extended rates pledge by one year.  According to the FOMC statement,  the central bank is effectively saying no to any rate hikes for the next 2 to 3 years and more importantly, is leaving the door wide open for QE3.  Unfortunately the individual projections for the first rate hike created more confusion than clarity, causing choppy trading in the U.S. dollar.  While the statement exuded a sense of solidarity, the individual projections show significant division in the central bank.  Of the 17 participants in the FOMC, 3 expect the Fed to raise rates in 2012, 3 in 2013, 5 in 2014, 4 in 2015 and 2 in 2016.   In other words, as shown in the following graph from the Fed, 6 FOMC participants see interest rates increased before 2014 and 6 see rates increased in 2014 or later.  As confusing as this may be, interest rate hikes are not on anyone’s radar.  Instead the key question was whether the Fed would fire up the printing presses this year and according to Bernanke additional bond purchases remains an option.  In fact, he spoke about the central bank’s readiness to expand their balance sheet so many times during his press conference that he could be hinting of plans to pull the trigger on QE3 in March.

Although the FOMC statement shows the influence of the new voters, the committee as a whole (voters and non-voters) shares vastly differing views on the outlook for the economy and monetary policy.  What the Fed should have done was simply release the projections of this year’s FOMC voters and adjust as necessary every year.   Nonetheless with 3 hawks and 1 dove replaced by 3 doves and 1 hawk, the U.S. is clearly left with a central bank that is more willing to consider the idea of increasing asset purchases.  In addition to releasing their projections for interest rates, the Fed also has a quasi-inflation target of 2 percent.

The Federal Reserve is not the only central bank expected to increase stimulus this year but judging from the price action of the dollar, it appears that the market believes the Fed will be among the first to act.  According to the monetary policy statement, the central bank believes that the U.S. economy is expanding moderately but economic growth over the coming quarters is expected to be modest with the strains in the global market posing significant downside risks. Previously, the Fed was looking for a moderate pace of growth but as business fixed investment slowed, out went any hope for a stronger recovery.  They now expect the economy to grow by 2.2 to 2.7 percent in 2012, down from their November forecast for 2.5 to 2.9 percent growth.  At the same time inflation is expected to “run” at an exceedingly low level which is perfect for a central bank that may be thinking about increasing monetary stimulus. This type of economic backdrop explains why the central bank decided to take the monumental step of releasing their forecasts for the Fed Funds rate – they wanted to ensure that there is zero ambiguity on monetary policy.  There is also good chance the central bank does not want investors to look at the improvements in the labor market and economic activity as reasons for why easy monetary policy is no longer needed. 

While the Federal Reserve has given investors very little incentive to buy dollars, there is still one very powerful reason for why the greenback could perform very well in 2012 and that is intensification of the European sovereign debt crisis.  As the greatest fear of policymakers around the world and the main reason why the Federal Reserve remains so dovish, this risk could easily turn into reality.  If Europe’s troubles worsen, wrecking havoc on the financial markets, deleveraging could prompt investors to seek safety in the greenback once again.

Here is a comparison of the two most recent FOMC statements 

  December FOMC Statement

Release Date: December 13, 2011

For immediate release

Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.