Fed's Interest Rate Inaction Won't Prevent Dollar From Strengthening

NEW YORK (TheStreet) -- If you worry that the resurgent dollar will lose its strength in the wake of the Federal Reserve's decision last week to leave interest rates alone, you shouldn't.

There is still a divergence in central bank policy around the world that will favor a continued rise in the value of the greenback, even if Fed Chair Janet Yellen and her colleagues continue to muddle around. Let's look back at some recent history of the U.S. currency and its rivals to understand what's happening.

Back in March 2014, the euro was worth $1.39. This is when the European Central Bank began to loosen up its monetary policy and indicated that it wanted the value of the euro to decline against the dollar and other major currencies.

At that time, the Federal Reserve in the United States had announced and confirmed through actions that it was in the process of tapering its quantitative easing program, which the Fed ended in October.

In late fall 2014, the European Central Bank began talking up its own version of quantitative easing, which it indicated that it would start early in 2015. Japan and other major nations also were engaged in quantitative easing or monetary policies that were quite loose.

Hence, the divergence in monetary policies. All else being equal, a looser monetary policy -- which typically includes lower interest rates -- makes a currency weaker against its rivals than a tighter monetary policy.

By March 13, 2015, the price of the euro had weakened to $1.05 as the Federal Reserve was letting out indications that it could begin raising its interest rate target, which had been at zero to 0.25% since December 2008.

But the Federal Reserve put off raising that target as the year went on.

After last week's meeting of the policy-setting Federal Open Market Committee, Yellen said it was unclear if the target rate would be raised anytime this year. Any move, she said, be driven by data.

Investors were surprised by the central bank's pessimistic view of growth in the U.S. economy and economic weakness around the globe.

Stocks tanked Thursday following the Fed's announcement and sold off Friday.

By the end of the week, some strategists were saying that it was going to be more difficult to keep a bullish outlook on the greenback.

Analyst talk by the end of the week indicated that it was going to be "tougher to be a dollar bull."

Bloomberg quoted State Street's Lee Ferridge, who summed up the basic argument. Ferridge said that divergence in monetary policies "may still happen, but clearly the strength of the divergence is much less than we were expecting before. And that's got to start weighing on the dollar."

The dollar weakened on Wednesday and Thursday but recovered on Friday. Early Monday, futures were showing the dollar up slightly vs. the euro.

It seems as if the Yellen-led Federal Reserve is not going to raise interest rates in the near future.

The question that must be answered then is whether the more timid Fed position will result in a smaller divergence between the monetary policies of the major central banks, no divergence at all, or a continued significant divergence.

 

The Bloomberg article cited says this, however:

"While strategists at Credit Suisse, Bank of America and Commerzbank say the dollar may weaken in the near future, they still forecast a stronger greenback by the end of this year. Credit Suisse and Commerzbank predict the dollar to rise to $1.09 and $1.08 against the euro, while Bank of America reduced its estimate this week to $1.05 from parity versus the single currency."

These forecasts seem relatively aggressive and would seem to assume that the ECB and Bank of Japan and others will have to resort to further rounds of quantitative easing in order to try and get their economies growing at all or keep their economies from falling into a deflationary spiral.

Given that the Fed still believes that U.S. economic growth will continue to be around 2.0% for the next several years, it is hard to believe that the Fed will be lowering rates during this time. In fact, the Federal Reserve staff forecasts that U.S. inflation will continue to rise back to 2.0% percent and that the target Federal Funds rate will continue to rise over the next three years.

This picture would seem to indicate that central bank divergence will continue into the future and the value of the dollar will continue to rise.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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