Dovish Fed outlook continues to weigh down on the US dollar - MUFG

Lee Hardman, Currency Analyst at MUFG, notes that the US dollar has continued to decline in the Asian trading session with weakness most evident against the yen resulting in USD/JPY moving closer to support at the 100.00-level.

Key Quotes

“The pair only briefly traded below the 100.00-level in the initial Brexit vote aftermath. A more sustained break lower would increase the likelihood of yen strength accelerating in the near-term. The US dollar continues to be undermined by more dovish expectations for Fed policy which were reinforced by the release overnight of an economic letter written by San Francisco Fed President Williams.

In the letter San Francisco Fed President Williams emphasizes that central banks and governments around the world must be able to adapt policy to changing economic circumstances. He argues that the new realities in the post-financial crisis world including the significant decline in the natural rate of interest pose significant challenges for the conduct of monetary policy.

The critical implication of lower natural rate of interest is that conventional monetary policy has less room to stimulate the economy during a downturn increasing the reliance on unconventional tools like central banks’ balance sheets, forward guidance, and potentially even negative rates. In this new normal, San Francisco Fed President Williams states that recessions will tend to be longer and deeper, recoveries slower, and risks of unacceptably low inflation will be higher.

He advises that policies should be adopted to help raise the natural rate of interest such as through greater long-term investments in education, public and private capital, and research and development. Governments should design stronger, more predictable, systematic adjustments of fiscal policy to support the economy. He also advises that central banks should consider adopting higher inflation targets or replacing them by a flexible price-level or nominal GDP target. However, he stressed that he is not advocating an abrupt reversal of current policies although he believes it is now time for experts and policymakers around the world to carefully investigate the pros and cons of these proposals.                 

The letter provides further evidence that Fed officials are becoming more pessimistic over the medium to long-term outlook for the US economy expecting growth to remain moderate and viewing current monetary policy settings are less simulative. It is reinforcing the markets’ dovish expectation that the Fed is likely to keep rates lower for longer weighing on the US dollar in the near-term.”