Dollar surges as hawkish Fed raises rates, maintains rate outlook, talks balance sheet reduction

The Federal Reserve hiked rates by 25 basis points as widely expected and issued a statement on Wednesday that, on balance, was not nearly as dovish as might have been expected given recent deterioration in economic data. While the Fed indeed gave a nod to recent declines in inflation and the fact that job gains “have moderated,” optimism prevailed as the statement asserted that inflation is still expected to stabilize around the Fed’s 2% objective in the medium-term and that US employment increases were still solid on average while the unemployment rate has decreased. The statement went on to declare that “economic activity has been rising moderately so far this year ... household spending has picked up in recent months, and business fixed investment has continued to expand.” Many of these phrasing choices were new and generally marked a more optimistic turn from the previous FOMC statement.

In line with these more hawkish statements, the “dot plot” that charts individual Fed members’ outlooks for interest rates, remained largely unchanged. FOMC members on average continued to see one more rate hike this year (for a total of three) as well as three more in 2018. There had been expectations prior to the FOMC announcement today that the Fed could have potentially lowered its rate outlook given the significant recent declines in inflation and job gains, but that was not to be the case. The Fed once again continued to state that it “expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.” One FOMC voter – Minneapolis Fed President Neil Kashkari – dissented, voting instead to keep interest rates steady.

One key element of the statement that had not been fully addressed previously was the issue of the Fed’s massive balance sheet. This time, the Fed went into some significant detail on how it planned to reduce that balance sheet, both in the FOMC statement as well as during the subsequent press conference with Fed Chair Janet Yellen. The statement read, “the Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated. This program, which would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities, is described in the accompanying addendum to the Committee’s Policy Normalization Principles and Plans.”

The market reaction to the rate hike accompanied by a more hawkish Fed stance provided a significant boost to the US dollar, as might have been expected. The dollar rose sharply against its major counterparts, in many cases erasing the losses suffered this morning after the release of disappointing US CPI and retail sales data. As also might have been expected after a rather hawkish Fed announcement, gold prices fell back, wiping out earlier gains. Stocks wavered and were slightly pressured, albeit just off record highs.

Going forward, could this be the boost that the dollar has so sorely needed in order to stage a comeback after several weeks of heavy pressure? With a hawkish Fed exuding confidence that inflation would rise, employment would remain strong, and economic conditions would continue to improve, the dollar may indeed begin to see the significant rebound that has mostly eluded it for at least the past month.

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