FX In Focus As Central Bank Policies Diverge

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Policies of major central banks are diverging. Elevated exchange-rate volatility may reflect the intensifying divergence. There are significant differences in how the U.S. Federal Reserve (Fed), European Central Bank (ECB), and the Bank of Japan (BoJ) are viewing the increasing inflation pressures in the global economy. During the pandemic, all of the major central banks were increasing their total asset holdings as a percentage of their economy’s GDP, and short-term interest rate policies were all at near-zero or even slightly into negative territory. Elevated inflation pressures as well as economies learning to live with the coronavirus have changed the nature of the game and resulted in very different guidance regarding policy responses (Figure 1).

Figure 1: Central Bank Assets

The Fed has provided guidance that it expects to end its asset purchases by March, and then commence the process of increasing short-term interest rates toward a more neutral policy – one that neither stimulates nor restrains the economy. Federal Funds futures suggest four rate hikes of a quarter percentage point each might occur in 2022 (Figure 2).

Figure 2: Implied Federal Funds Rate

The European Central Bank has indicated it plans on continuing versions of its asset purchase programs through 2022 and 2023, and thinks it is much too early to contemplate increasing short-term rates. Currently, the ECB’s overnight deposit policy rate is in negative territory, and futures markets suggest the ECB policy rate will stay below zero all the way through 2022 (Figure 3).

Figure 3: Implied Euro Deposit Rates

The Bank of Japan is welcoming the possibility of some inflation pressure, to break the back of several decades of consumers’ embracing the psychology of deflation. Asset purchases are likely to continue, and no changes are anticipated in the near-zero interest rate policy.

The differentials in 10-year yield on Government bonds are telling. US 10-year Treasuries yield 1.8% more than German 10-year bonds and 1.6% more than the yield on 10-Year Japanese Government Bonds (or JGBs) (Figure 4).

Figure 4: Global Bond Yields

With exchange rates, many factors are influential, including geo-political risks, relative economic growth, and a country’s ability to attract global capital flows. Differences in central bank policies, however, are always considered a key factor in modeling exchange rates.

Other factors will make a difference in the future pattern; however, monetary policy is likely to be a headwind for the Japanese yen and the euro against the US dollar, given the upcoming short-term interest rate hikes anticipated by the Fed. 2022 may well usher in more currency volatility than has been seen in a decade as central bank policies increasingly diverge (Figure 5 and Figure 6).