Federal Reserve reignites euro-dollar currency tensions

Change to the Fed’s inflation target sets off renewed dollar weakness and triggers alarm in the eurozone

Federal Reserve chair Jerome Powell announced a significant policy shift in the way the Fed targets inflation at his Jackson Hole speech a fortnight ago, moving away from a rigid 2 per cent inflation target and replacing it with a 'a flexible form of average inflation targeting'. AFPShow less

Currency tensions between the US and the eurozone were reignited in the past fortnight, triggered by a change to the Federal Reserve’s inflation target, which set off renewed dollar weakness. However, with the euro-dollar exchange rate beginning to probe the symbolically important 1.20 level last week, this prompted European Central Bank officials to attempt to “talk it down”, a process that was helped in part by better-than-expected US jobs data.

All of this sets up a pivotal ECB meeting in the coming week, and a critical month for markets. With equity markets having enjoyed a positive summer overall, the onset of September saw some recalibration of the risks on the horizon as autumn comes into view.

During his Jackson Hole speech two weeks ago, Fed chair Jerome Powell announced a significant policy shift in the way the Federal Reserve targets inflation, moving away from a rigid 2 per cent inflation target and replacing it with a “a flexible form of average inflation targeting”. Inflation “moderately” higher than 2 per cent will now be tolerated following periods when price growth has undershot the target, with the change suggesting that interest rates in the US will remain lower for longer.

It also opens the way for the Fed to provide more monetary stimulus through quantitative easing in the coming months, particularly if Congress cannot agree on another round of fiscal stimulus. Mr Powell acknowledged there has been a flattening of the Philips curve in recent years – the inverse relation between unemployment and inflation – and “shifts in estimates of the natural rate of unemployment”, suggesting that the Fed will not act automatically to dampen price pressures as the unemployment rate falls.

The euro-dollar exchange rate reached a high of 1.2011 in the days following the shift in the Fed’s policy stance, up from 1.18 on the day of Powell’s speech, as expectations of a weakening dollar trend became entrenched. However, this seemingly set off alarm bells at the ECB, which brought out a number of its key policymakers to talk about the potential damage to the eurozone economy from an appreciating single currency.

In particular, ECB chief economist Philip Lane said that while the ECB does not target the exchange rate, the EUR/USD rate matters, while highlighting that there has been a repricing in the euro in recent weeks.

Dollar weakness might become a more intractable problem, especially with the Fed now seemingly encouraging it

While some of this repricing clearly stems from positive developments in the eurozone, such as the announcement of the EU’s €750 billion (Dh3.26 trillion/ $887.8bn) recovery fund, the impact of the Fed’s policy shift undoubtedly had a more sudden and direct impact. Mr Lane highlighted the central role that the EUR/USD exchange rate plays in ECB monetary policy setting, saying that “it will be important to recognise that the euro-dollar rate is also endogenous to monetary policy”.

Other officials talked about the euro’s rise against the dollar risks holding back the eurozone economy, undermining competitiveness at a time when global demand is already soft. The collective effect of such remarks was enough for the euro to pullback from the week’s highs, as attention turned to the ECB’s likely response at its policy meeting in the coming week.

Speculation of a dovish signal from the ECB combined with stronger-than-expected US jobs data, which saw the unemployment rate fall to 8.4 per cent in August from 10.2 per cent, saw the EUR/USD rate end the week much lower at 1.18, but its next move will now depend on what the ECB decides to do.

Should it lower its inflation projections in light of the ongoing strength of the euro, then the ECB is likely to strengthen its own “low for longer” message about its interest rates, which may result in an exchange rate truce, albeit temporarily.

How long this will last, however, is unclear as markets readjust their perspective about the coming months now that summer is behind us. July and August’s equity market rally is already coming under greater scrutiny now that September has begun, and there is also a greater sense of the risks surrounding the US election, now only two months away.

Against such a backdrop, dollar weakness might become a more intractable problem, especially with the Fed now seemingly encouraging it –and making it a much harder task for the ECB to fight it.

Tim Fox is a prominent regional economist and financial market analyst