The U.S. dollar has been moving upward against the euro and yen. There have been several factors involved, but the primary driver has been the Federal Reserve’s move away from accommodation well ahead of the European Central Bank (or ECB) and the Bank of Japan. Now, there are signs the ECB may move next.
Seeing U.S. consumer price inflation soar over 8%, the Fed has commenced raising rates and will soon start shrinking its balance sheet. Federal funds futures currently suggest a very rapid pace of rate hikes in 2022, ending up around 3% to 3.5% in the first half of 2023, at which time the Fed may take a pause.
Euro-area inflation is now over 7%, yet the ECB still has its short-term target deposit rate at a negative half percent. Recently, several ECB board members have indicated they are ready to raise the target rate to zero. That is a small move relative to what the Fed is planning, but getting back to zero is a first step toward responding to the elevated inflation environment.
Japan's inflation is only running at about 1%, but signs are pointing that more inflation might be coming. For now, the Bank of Japan remains committed to near-zero rates across the maturity spectrum. The Bank of Japan controls both short-term rates and actively has a yield curve control policy to influence the Japanese government's 10-year bond. This is reflected as a large gap opening up among 10-year yields, with the U.S. the highest, German government bonds in the middle, and Japan bringing up the rear.
While inflation is driving the policy shifts at these central banks, the currency moves will be a cause for discussion. The challenge for the Bank of Japan, as it may develop for the ECB, is how much currency depreciation to tolerate. So far, the Bank of Japan is happy to stay put on the near-zero-rates policy and accept currency depreciation while other central banks, facing higher inflation, start to make their moves.