- The ECB and the Fed are ending their financial crisis policies. The ECB has not enacted extraordinary measures despite talking about them for weeks and the Fed is terminating QE.
- The economic recovery in the U.S. is stronger and with the return of normalizing rate policies, U.S. rates will rise first, all else being equal.
- The ECB is on hold, the Fed is not and that is why currency markets ignored Draghi's press conference comments and ran with Yellen's.
- Potentially higher U.S. rates first is why the dollar has strengthened against the euro in the past week, and as the euro/dollar pair goes so goes the currency market.
In his news conference two weeks ago following the ECB's policy decision President Mario Draghi explicitly noted the importance of the euro exchange rate to European economic growth and inflation.
Let me start first with a standard statement. I mean, the exchange rate is not a policy target for us. But the exchange rate is very important for growth and price stability. And there is no doubt that if we look backward to the trough of 2012, -- to the trough in the exchange rate in 2012, and we look at the exchange rate today, and we ask ourselves the question, how much has this counted for the low inflation that we see today?
The implication was clear, ignore our standard disclaimer. The strong euro has had a negative effect on growth and inflation, the ECB's two most pressing concerns.
If Mr. Draghi was hoping to reverse the effect of his "whatever it takes" defense of the euro and the euro zone from two summers ago he failed. Over the subsequent two weeks the euro gained 1.6 percent against the dollar closing at 1.3934 on March 18th the day before the FOMC policy meeting.
Federal Reserve Chair, Janet Yellen was not trying to talk up the dollar in her press conference following Wednesday's FOMC statement. When asked by a reporter for a definition of 'a considerable time' the phrase the Fed used to describe the lag between the end of asset purchases and the first Fed Funds rate hike she at first demurred and finally said it might be six months.
At the current reduction of $10 billion per FOMC meeting that would leave $5 billion in purchases after the October 29th meeting and eliminate them at the December 17th event. A rate increase six months after either date would be about a year sooner than market expectation. The dollar promptly climbed 1.3 percent, the largest two day gain against the euro since January.
Mr. Draghi was trying to weaken the euro and Ms Yellen was not. Yet the currency markets ignored Mr. Draghi's deliberate words and pounced on Ms Yellen's inadvertent ones.
Central bank rhetoric can be a powerful tool. Mr. Draghi's defense of the euro and the eurozone the summer of 2012 was one of the most successful currency interventions in history. But words work best when they are backed by action or the realistic potential for such. In that comparison the Fed and the dollar now have a distinct advantage over the ECB and the euro.
Before the March 6th meeting ECB officials talked for weeks about the possibility of non-traditional policies. But the governors choose not to act on even the mildest of its choices, ending the sterilization of its €175 billion debt portfolio. Negative interest rates or asset purchases now seem far-fetched.
Because the ECB has proved unwilling or unable to act on its rhetoric, Mr. Draghi's attempt to manipulate the euro exchange rate fell on deaf ears. While we can be sure that Mr. Draghi would prefer a lower euro, his comments no longer seem tied to actual bank policy.
Prior to last Wednesday's FOMC meeting, Ms Yellen's supposed dovish and labor oriented sentiments were the source of much market comment. But the Fed judgment on asset purchases is unchanged. Unless the U.S economy weakens its asset purchases will end this year, and their market impact much sooner than that.
The continued taper confirmed the change of Fed policy. When combined with Ms Yellen's unexpected comment, even though she immediately qualified it with concerns about the lack of inflation, it drove the dollar sharply higher.
Behind the opposite currency market reactions to Ms Yellen's and Mr. Draghi's recent comments are the differing assessments of each bank's near and medium term policies.
The ECB is on hold. If economic conditions worsen, particularly if disinflation becomes deflation, it may yet turn to unconventional monetary policies, but the odds are against it. The Fed is ending quantitative easing, its quintessential financial crisis policy. Unless the U.S. economy falters the next policy move, when it comes, will be a rate increase.
There is another aspect to the Fed and ECB policy choices this month beyond their immediate market impact.
The ECB and the Federal Reserve have turned from the crisis driven policies of the past five years.
By not implementing negative interest rates and by ending asset purchases, the ECB and the Fed imply that their next policy moves will be from the standard central bank interest rate playbook. Markets have been waiting for return of normal bank policy for so long that is not surprising no one seems to have noticed.
Neither policy change is decisive. Falling prices in Europe would, no doubt, bring ECB action as would a decline in U.S. job creation. The central banks have assumed the role as chief defenders of the world economic system, laissez-faire policies are no longer a choice in Washington or Frankfurt.
If the world economy continues to improve, as the banks themselves predict, then it is likely that this month saw the end of the central bank response to the financial crisis and recession. A return to normal central bank policies that will have been predicted by last week's run in the U.S. Dollar.