The two most important central banks in the world are thus drifting apart in monetary policy. This tendency is likely to intensify in the coming months.
The strategy is having an impact: no more interest rate hikes for 2022 will be priced in on the money market. This is mainly reflected in the euro exchange rate.
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The common currency recently fell to its lowest level in over a year and was temporarily trading below the US $ 1.13 mark on Monday. Since the beginning of June, the euro has lost almost eight percent of its value against the dollar. And many experts believe the downward trend could last longer.
“As the world moves towards normalization of monetary policy, the ECB is likely to be at the end of the line when it comes to tightening,” said Paul Mackel, head of currency strategy at HSBC. He therefore expects the euro to come under further pressure.
The economist of the US bank Citi, Ebrahim Rahbari, sees it similarly. “We are still pessimistic about the euro until 2022.” He, too, attributes the poor outlook for the euro to the growing interest rate differential between the US and the euro area. Citi predicts that the Fed will announce a faster shutdown of its bond purchases in December and will raise rates three times in the coming year.
If interest rates rise in the US, that tends to support the dollar. Because it is becoming more attractive for international investors to invest in American interest-bearing paper. Conversely, if the ECB persists in its loose monetary policy, it weakens the euro.
The Fed may be scaling back bond purchases faster than expected
For investors, it is more worthwhile to borrow in euros at particularly low interest rates and to invest the money in other currency areas – which tends to depress the euro exchange rate. Less than two weeks ago, the futures markets for the euro area even priced in two rate hikes for 2022 at times, despite signals to the contrary from Lagarde.
In the meantime, the mood has shifted and market expectations have come much closer to the announcements made by Lagarde.
In contrast, several Fed officials in the US urged that monetary policy be tightened more quickly than previously planned. Fed Vice Chairman Richard Clarida said it might be appropriate to “talk about a faster pace in reducing our balance sheet” at the next Fed meeting in December.
Other of his colleagues, such as Fed Governor Christopher Waller and the head of the St. Louis Regional Fed, James Bullard, made similar views. Both urged to end the bond purchases sooner than planned.
As recently as October, these amounted to $ 120 billion. In early November, the Fed decided to cut it by $ 15 billion a month. Bullard now brought a reduction of 30 billion dollars a month into play.
This means that the process of melting down bond purchases – known as tapering in technical jargon – could already be completed in March and not in June 2022. This would also enable interest rates to be increased earlier.
The ECB and Fed meet almost at the same time
Unlike in Europe, there is currently no new corona wave in the USA. As the largest economy in the euro area, Germany is particularly hard hit. In addition, many economists estimate the inflation risks for the USA to be greater. In October consumer prices rose there by 6.2 percent – more than expected.
A warning sign is that, for example, rental prices have also increased significantly. These make up around a third of the basket of goods with which inflation is measured and change rather slowly. That speaks for a faster tightening in the USA.
Whether and how much the ECB and the Fed will drift apart remains to be seen in mid-December. Then both central banks will meet almost at the same time, the Fed meeting will end on December 15, that of the ECB on December 16.
The ECB bought bonds worth around 90 billion euros in October. She also has to decide how to proceed with it. Central bank chief Lagarde has already signaled that she wants to end the PEPP program launched specifically in the pandemic in March 2022.
In addition, there is an older purchase program with the abbreviation APP, through which the ECB buys bonds worth EUR 20 billion a month. This could be topped up temporarily in order to prevent an abrupt demolition of monetary policy support after the end of the PEPP.
Whether and to what extent it will do so depends heavily on the new inflation forecasts that the central bank will present at its meeting. For the first time, these will last until 2024.
Many analysts anticipate that the ECB will have to revise its assumptions upwards. The stronger a possible upward adjustment, the less likely the central bank is to expand its bond purchases – and the sooner an interest rate hike can be expected.
The markets have recently adjusted their expectations about the monetary policy of the Fed and the ECB – and are assuming a much faster tightening in the USA. That depresses the euro and gives the dollar a boost.
But betting on this is not without risk. The Bank of England recently provided a cautionary example. The markets had firmly expected that it would hike rates in early November. But the central bank refrained from doing so, causing confusion among investors.
More: The big inflation bet of the ECB – Is central bank chief Lagarde underestimating the inflation risks?