The Fed will likely continue to tighten as planned
Aa
Share
The Fed
Over much of 2022, the Federal Open Market Committee (FOMC) repeatedly surprised financial markets at its meetings by showing a more aggressive expected policy path than had been predicted by the markets, leading to a continual ratcheting higher of rate expectations that we believe was a significant driver of USD strength. This trend was underlined by fairly constant hawkish commentary by FOMC officials outside of Fed meetings too. Now, we believe that the market-expected policy path is more in line with the actual Fed outlook, and so we expect this influence to dissipate.
The Fed will likely continue to tighten as planned, but we do not expect much more tightening from current levels. Once the Fed finally realized the inflation problem was not “transitory,” it tightened financial conditions enough to give it a chance of achieving some disinflation, and the markets now appear to be on board with the policy path. Fed funds futures are now more closely reflecting the Fed’s own projections, as encompassed in its “dot plot” (Exhibit 27 on the next page). Softer economic activity and Dec-22 Dec-22 sentiment suggest that further upside surprises to the fed funds rate are now limited, and downside surprises to rates may even emerge. This would take further steam out of the USD’s progress.
Structural issues remain
While the above discussion focuses on the current and anticipated evolution of cyclical factors, it is worth bearing in mind that the US continues to face structural challenges that are unlikely to be supportive of the USD on a longer-term basis too. The US remains in a “twin deficit” situation, with both current account and fiscal account balances in longterm deficit (Exhibits 28 and 29 on page 14). As a counterpart, US government debt has been rising relative to GDP for some years now (Exhibit 30 on page 14), with looser fiscal policy in response to both the global financial crisis and the pandemic seeing debt rise sharply over the past decade. The IMF estimates US government debt has reached 122% of GDP in 2022 from 53% of GDP in 2001. These long-term structural concerns underpin the cyclical dynamics described above in terms of leaving the USD vulnerable to adjustment from its current overvalued levels, in our view.
This article is part of the report
