How will the FED’s rate hike impact the USD?

The Fed approved a 0.25 percentage point rate hike at the recent meeting.

It is possible that the FED could throw in a 50-bps hike along the way, but Powell said that the FED will strive to avoid uncertainty. Mr.Steve Barrow, Head of Standard Bank G10 Strategy, takes this to mean that if inflation data requires a 50-bps move, the Fed would alert the market to this probability before the meeting in question to limit  its impact. In short, just like at the recent meeting, he does not believe that FOMC meetings will lead to big bouts of volatility after the announcement. This being said, there are two ways that inflation is likely to come back to near target levels in coming years. One is via the sort of policy tightening that the FED projects. While that’s possible, he is not sure that it is very likely. The other way is that factors, such as the Russia-Ukraine war and the FED's falling behind the curve cause a tightening of financial conditions that brings about the required fall in inflation.

This path is still the most likely one even though the FED has lifted its rate hike forecasts considerably. The danger with this latter route is that it is not under the FED’s control and that it runs a greater risk of excessive financial tightening that weakens the economy more than the FED anticipates and could even lead to a recession. In other words, the FED has a bad record of achieving a smooth landing for the economy, and this time is not going to be any different.

But for all the FED’s difficulties in combatting inflation risk, the situation facing the Bank of England and ECB is far worse given their energy reliance on Russia. Not only will there be bigger inflationary effects, there will be bigger hits to GDP.

In Mr. Steve Barrow’s view, that puts their currencies at a disadvantage to the dollar, at least while we are in the teeth of this conflict. Hence, he looks for euro/dollar to fall to 1.05, or below and for sterling/dollar to slide to 1.25 or lower in the next few weeks and months. What he also thinks is worth pointing out again is how we have reduced our longer-term forecasts for the euro. This is because the adverse effects of the conflict in Ukraine will persist for some time in terms of the negative terms of trade shock, the damage to euro zone budgets, the refugee situation, and more.

"The chances of a recession in the euro zone are far higher than in the US, even if they do still sit below 50%. For all this, we do still see a higher euro against the dollar in time, but our two-year forecast has come down from 1.40 before the war to 1.25 and, for the next year, our 1.15 forecast is not too far above current levels or the forward rate", Mr.Steve Barrow said.