How will the US dollar move under an easier monetary policy?

The prospect of easier monetary policy next year could help limit  the US dollar’s upside

>> Will the US dollar see a further decline?

Speculation that central banks can pull off a soft landing has been increasing – but it seems far too soon to declare victory on this score. Growth in G10 countries is proving more robust than anticipated, and headline inflation is falling. Tight labour markets and a surfeit of savings accumulated during the pandemic have cushioned the blow from rapid rate hikes. The legacy of quantitative easing by central banks has diminished the contractionary impact of higher policy rates, even though central banks are now running down their balance sheets. Labour markets will continue to loosen, savings will diminish, and the stimulative effects of past QE will fade.

The said factors will restrict the room for economic growth to recover significantly; hence, next year’s GDP growth in G10 nations is unlikely to be materially different from 2023, and may even conceivably be much worse.

However, as well as lingering concerns on the growth front, it seems that policymakers will not be able to push inflation down to target levels (which is 2% for most) and keep it there sustainably. There are just too many long-term structural factors, such as demographics and deglobalisation, that suggest inflation has taken a permanent step higher from the sub-target levels we saw for most countries in the pre-pandemic period.

The key question here is whether this step-up is to levels so far above target that it will necessitate a prolonged period of high policy rates and, very possibly, deep recessions to try to resolve the problem. Fortunately, perhaps, the Standard Bank’s forecast is not that malign. This bank believes that the rise in structural inflation is more likely to be modest, probably in the region of 3% for many countries. That might still seem like bad news – but we should not forget that inflation was routinely too low in the pre-pandemic period; hence, a situation where inflation is more often above 2% than below would not be a bad outcome.

Higher inflation becomes dangerous when it rises to very high levels, as we’ve seen recently, because it tends to be more volatile and inflation expectations become unanchored. But a decline from current levels to the 3% region for most nations would not fit this description, and should allow central banks to unwind a good part of the policy tightening undertaken since 2021.

A corollary of structurally higher inflation is that G10 policy rates and bond yields will likely be higher than in the pre-pandemic years. This is not a controversial view. The controversy surrounds the extent to which policy rates and yields will be higher. All would probably agree that the era of zero policy rates and sub-zero bond yields is over. Forward curves do not price rates falling back to these sorts of levels.

In fact, forward curves generally suggest that policy easing will be quite modest, with the US curve, for example, priced for around 100 bps of rate cuts in 2024. The Standard Bank believes that the markets are underplaying the easing that will take place next year, partly due to central bankers consistently stressing the need for a higher-for-longer strategy. However, this bank does not expect them to say anything different at this stage.

>> What makes the US dollar vulnerable?

To talk now about the scope for rate cuts over the long haul would risk undermining the progress in tightening financial conditions to date, and perhaps even prompt further rate hikes in the near term. But, when it comes to the point that central banks are satisfied with their anti-inflation progress, their language might change significantly, ushering in both the pricing of deeper rate cuts than are assumed right now and, ultimately, the delivery of policy easing from mid-2024, for most, and 2025. The prospect of easier monetary policy next year should help limit  the dollar’s upside and start to deliver a significantly weaker greenback in the coming years.

“We look for a 10%-plus depreciation for US dollar over the next year or two. However, there is an important qualification here, which is that policy easing occurs in the context of a broad soft-landing scenario for G10 countries that allows bond and stock prices to flourish. If, instead, rate cuts occur in the context of a hard landing, with asset-price implosion, we would be more likely to see dollar strength, not weakness”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.