Back \ FXT Analysis \ US Dollar on Track to Rise to New Heights as Fed Steps up Hawkish Settings

US Dollar on Track to Rise to New Heights as Fed Steps up Hawkish Settings

The US dollar is set to maintain its upward trajectory in 2022 and rise to further heights against other major currencies, as both the Federal Reserve and President Biden step up their determination to contain raging inflation.  

The Federal Reserve has just unveiled its biggest increase to the target interest rate in nearly three decades, demonstrating its determination to tackle breakneck inflation in the US economy. 

Source: Board of Governors of the Federal Reserve System (US)
Source: U.S. Bureau of Labor Statistics

On 15 June the Fed announced a 75 basis point increase in the target rate, for the biggest hike since 1994. Fed chair Jerome Powell also indicated that a similar increase could follow in July if inflation doesn’t start to ease. 

The 75 basis-point increase is the largest hike since 1994, and ahead of consensus expectations of a 50 point increase for June.  

The move arrived after the official inflation print for May came in at a four-decade high of 8.6%, despite prior efforts by the Fed to contain price gains with back-to-back rate hikes in April and May, leading to a cumulative increase of 75 basis points. 

While extremely high levels of inflation are significant of a decline in the purchasing power of a currency, and would normally lead to a corresponding fall in its exchange rates, the US dollar has instead risen higher compared to other major currencies this year, including the euro and the Japanese yen.  

The US Dollar Index rose to a two-decade high of 105.42 on Tuesday, in anticipation of the more aggressive rate hikes from the Fed that Powell subsequently made good upon.  

The reason for this increase is that the central banks of both the Eurozone and Japan have thus far refrained from following the hawkish stance of the Fed. This means that US dollar-denominated assets will generate stronger returns compared to those denominated in the euro or the yen.  

Japan’s economy has thus far remained free from the raging inflation which has convulsed advanced Western economies. In May the core consumer price index in Tokyo rose just 1.9% compared to the same period last year.  

Not only is this rise far less than the comparable figures for the Eurozone and the US, it also falls short of the Japanese central bank’s inflation target of 2%.  

Instead of untamed inflation, the Japanese economy continues to struggle with the deflationary pressure which has beset the economy for over two decades.  

The Eurozone is a different story, contending with inflation levels approaching those of the US. Its official inflation print was 7.4% in April, while Eurostat expects the figure to rise further to 8.1% in May.  

Europe could be especially susceptible to inflation due to the outbreak of military conflict in Ukraine, which has jeopardised the supply of energy sourced from Russia.  

In sharp contrast to the hawkish tenor of the Fed however, the European Central Bank (ECB) has been dilatory in its response to raging inflation, after maintaining negative interest rates for a period of eight years.  

The ECB has only just unveiled plans to raise interest rates in July – in what will be the first hike since 2011. The size of the hike will also be comparatively modest, with a 25 basis point increase on the cards, despite calls from many observers for a 50 basis point lift.  

ECB chair Christine Lagarde has said that the Eurozone will not make an exit from negative interest rates until the end of the third quarter of this year.  

Following an emergency meeting of the ECB held on 15 June to address a bond market rout and concerns of a fresh debt crisis, ECB Governing Council member Mario Centeno said that the pace of interest rate hikes would only be “gradual.” 

Given the comparatively soft attitude of both the ECB and BOJ towards their respective interest rate regimes, it is no surprise that the hawkish stance of the Federal Reserve is driving gains in the US dollar despite torrid inflation levels since the start of 2022.