How will FED’s tapering impact USD?

FED' tapering may be benefit USD 

Central banks that undertake a relative increase in asset purchases tend to experience currency weakness and vice versa. With the Fed on the verge of announcing a tapering of its bond purchases, the dollar will surely rise. But is that correct?

There have been lots of estimates done over the years to try to determine just what quantitative easing (QE) costs a currency when it is announced and benefits a currency when it is ended. One of the most recent investigations by economists at the ECB suggests that a relative one percentage point increase in ECB QE compared to the US over a period of 9 months lowers euro/dollar by 0.35% over this time. It is said that this is about the same as a 2-bps reduction in eurozone rates relative to the US. As central banks normally change QE much more than 1 %-point relative to other central banks, the effect on the currency can seemingly be quite significant by these calculations. So, should we be prepared for a surge in the dollar? Not so fast.

The first thing to bear in mind is that this is a relative calculation. We don’t just need to consider what the Fed is likely to do but other central banks as well and, for the most part, they are going in the same direction as the Fed. The Bank of Canada has started to taper and the RBA will do so from September. As for the ECB, its EUR1.85tr target for asset purchases under the Pandemic Emergency Purchase Programme (PEPP) will be hit next March and sometime soon, probably in Q4, it is likely to announce its plans. These will involve the Bank buying considerably fewer bonds after next March than it is doing right now. 

Meanwhile, the Bank of England will reach its GBP895bn QE target around the end of the year and, here too, any future buying plans will be scaled down substantially. In short, the symmetric nature of the Covid-19 shock means that many central banks have undertaken QE together and will broadly scale it back together. If we go back to 2014 when the Fed was tapering, the ECB was still dealing with the travails of the eurozone debt crisis and, by 2015 it had started its own QE program. In other words, the Fed and ECB were going in opposite directions but now they will be going down a similar path even if the timing and speed of their moves differ a bit.

There is another issue as well, which is that successive bouts of QE seem to have made the market believe that it is here to stay. That, even if a taper occurs, central banks will have to fire up the monetary printing presses again in the future when the next crisis hits because policy rates are still too close to the zero lower bound to be cut meaningfully. If the market believes that there’s less permanence to tapering, its ability to impact the exchange rate is diminished.

A final aspect is the “need” for tapering. Mr. Steve Barrow, Head of Standard Bank G10 Strategy said, the risks in the US, such as rising inflation, necessitate that tapering is not just required but probably required at a faster pace than elsewhere, and especially in the eurozone where price pressures remain a lot more quiescent. Of course, US price pressure may ease sharply but we would not bet on it, and if the market thinks that tapering represents little more than closing the stable door after the (inflationary) horse has bolted, it is hard to see it benefit the dollar.