On Tuesday, the Commerce Department will publish international trade data for August. The numbers will, undoubtedly, show a deficit – the U.S. has run a trade deficit every year since 1975. This, in turn, implies that the U.S. dollar exchange rate is too high – we buy everyone else’s stuff because it’s cheap; they don’t want to buy ours because it’s expensive. That being said, even as Americans have sent dollars overseas to buy goods and services, these dollars have returned to buy U.S. stocks and bonds, fueling a booming stock market and allowing the federal government to borrow relatively cheaply.
A too-high dollar has had its costs, also, however. It has contributed to the loss of millions of manufacturing jobs with all the social ills that have accompanied such a decline. It has increased our foreign debt. Just as we, as a nation, have lived above our means in the past, we will have to live beneath them in the future. And it has amplified populist calls for tariffs as a solution – even though history clearly shows that tariffs trigger retaliation leading to both slower economic growth and higher inflation.
It would be better for America if the dollar were gradually to fall to a level commensurate with trade balance. Such a move would also have major portfolio implications, boosting the dollar-denominated return on international equities, which have underperformed U.S. equities for many years. However, despite declining from an apparent peak in September 2022, the exchange rate has largely moved sideways since then.
So where does the dollar go from here? The answer depends on trends in economic growth, inflation, trade, fiscal policy and, most of all, interest rates. But not just U.S. trends – rather how these trends evolve in the U.S. compared to other major currency blocks. One way of examining this issue is to look at the world from the perspective of four banks: The Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan, commonly referred to as the Fed, the ECB, the BoE and the BoJ respectively. Looked at from this angle, it is still hard to forecast a near-term dollar slide.
The Fed: Slow Easing on a Soft-Landing Path
Of all the major central banks, the Fed probably feels the most comfortable today. Having held the federal funds rate in a range of 0%-0.25% since the early days of the pandemic, the Fed raised rates 11 times between March 2022 and July 2023 to a range of 5.25%-5.50%. Then, after holding at this level for 14 months, it finally cut the funds rate by 0.50% last month to a range of 4.75%-5.00%.
Since its mid-September move, data have generally shown continued economic momentum. In particular, revised GDP data showed stronger growth in both output and income in recent years with the economy logging solid 3.0% real GDP growth both annualized and year-over-year for the second quarter. Our own models suggest a similar annualized pace for the third quarter, powered by continued strong gains in consumer spending, although gradually slowing employment growth and a low personal saving rate should contribute to a moderation in economic growth going forward.
Inflation is continuing to decline with the consumer price index this week potentially showing a year-over-year gain of just 2.3% for September. This could imply a year-over-year increase in the personal consumption deflator of 2.0% - hitting the Fed’s long-run target. While inflation could nudge higher in October, throughout 2025 the economy should see plenty of readings at or below 2.0% consumption deflator inflation.
One potential complication for future monetary policy could be any dramatic changes in fiscal policy after the election. However, with the exception of tariffs, any major moves would require the agreement of both houses of Congress. If the election results in divided government, major fiscal stimulus would be unlikely. Conversely, a one-party sweep might result in bigger tax cuts or spending increases, causing the Fed to slow its easing strategy.
In the absence of fiscal or other shocks, the most likely path for the Fed is to “follow the dots” from the September summary of economic projections. That is to say, it would implement a further 50 basis points in cuts to the federal funds rate this year, a further 100 basis points in 2025 and a further 50 in the following year, cutting the federal funds rate to a long-term range of 2.75% to 3.00% by the middle of 2026.
The ECB: Managing a Fragile Expansion
The ECB began its post-pandemic tightening three months later than the Fed, in July of 2022 and continued to raise rates until September 2023 by which time it had boosted the rate on its deposit facility from -0.50% to 4.00%. Like the Fed, it then went on pause but has cut twice in recent months, first by 0.25% in June and then by a further 0.25% in September bringing the rate down to 3.50%.
The ECB faces a more complicated situation than the Federal Reserve for a number of reasons. First, economic growth in the eurozone is not nearly as robust as in the United States. Real GDP growth was just 0.8% annualized, in the second quarter, reflecting a very subdued 0.6% year-over-year gain. In addition, composite PMI data for September showed contractions for the month across Germany, France and Italy. The eurozone unemployment rate, at 6.4% remains low. However, employment growth, at 0.8% year-over-year in the second quarter was less than half of the U.S. pace, with no sign of significant productivity gains.
The region is suffering, to some extent, from a slowdown in export markets, still high energy costs and cautious consumers. Demographics are also weak with deaths exceeding births in Germany, Italy and Spain while European Union budget rules, along with Germany’s self-imposed budget constraints are limiting any fiscal expansion. All of this suggests very slow growth going forward.
The good news for the ECB is that inflation has fallen very steadily with the year-over-year harmonized consumer price index (HICP) inflation rate falling to an estimated 1.8% in September 2024 from a peak of 10.0% two years earlier. While inflation excluding energy remains a little higher, at 2.6%, given the sluggishness of demand, the ECB should have little to fear in terms of renewed inflation pressures.
Consequently, we expect that ECB officials will accelerate their rate cutting process from the once every second meeting approach that they adopted last year to cuts at each meeting starting with a 25 basis point cut at the governing council meeting scheduled for next Thursday, October 17th.
The Bank of England: A Stickier Inflation Problem
In the wake of the pandemic, the Bank of England started tightening earlier than the Fed or ECB, boosting its key short-term interest rate, (known as bank rate), from 0.10% to 0.25% in December of 2021. This rate was then increased 13 further times to a peak of 5.25% in August of 2023. In August of this year, it implemented a first cut, reducing the rate to 5.00%. This rate was then maintained at the September Monetary Policy Committee meeting.
The U.K. economy is seeing slightly stronger growth than the eurozone, with year-over-year real GDP growth of 1.2% in July and a composite PMI index reading of 52.6 in September. However, with an unemployment rate of 4.1%, still low labor force participation and weak productivity growth, real GDP growth from here is expected to be sluggish. In addition, given fiscal constraints, it is unlikely that the first budget from the new Labour government, due out a the end of this month, will add significantly to aggregate demand.
As is the case in the United States and the eurozone, CPI inflation has fallen back significantly in the UK since peaking at 11.1% year-over-year in October 2022. Indeed, at 2.2% year-over-year in September, it is close to the Bank of England’s 2.0% target although both wage increases and services inflation are looking stronger, pointing to potential inflation stickiness going forward.
In an interview last week, the Bank of England Governor, Andrew Bailey, suggested that they could be a bit more aggressive in cutting rates going forward if inflation continued to cool, presumably starting with the next policy meeting on November 7th. If this results in rate cuts at every meeting then the BOE could end up cutting more sharply than the Fed. It should be noted that, like other central banks, the Bank of England holds eight monetary policy meetings per year. However, the Bank of England would have to implement such a policy very carefully since a too-rapid easing could undermine the value of Sterling, potentially boosting both inflation and long-term interest rates.
The Bank of Japan: New Political Leadership
Unlike other central banks, the Bank of Japan is in tightening mode, having held its key policy rate in a narrow range of between -0.1% and +0.5% for almost 30 years. In March of this year, they raised the rate from -0.10% to +0.1% and in July they increased it further to 0.25%. Markets had anticipated further tightening in the months ahead, particularly with the selection of a new Prime Minister, Shigeru Ishiba, who was perceived as a monetary hawk. However, after meeting with the Governor of the Bank of Japan, Kazuo Ueda, last week, Prime Minister Ishiba declared that the Japanese economy was “not ready” for another rate hike.
It is a debatable point.
Japanese economic growth continues to follow a sawtooth pattern, rising to an annualized 2.9% in the second quarter following declines in two of the three previous quarters. On a year-over-year basis, second-quarter real GDP was down 0.9%. However, composite PMI data for September show Japan to be in solid expansion mode. Headline CPI inflation looks strong at 3.0% year-over-year while core-core inflation (which excludes fresh food and energy) is at 2.0%, exactly in line with the Bank of Japan’s 2.0% target.
Given Prime Minister Ishiba’s comments it is unlikely that the BOJ will tighten at its next policy meeting on October 31st. A further rate hike could be in the offing for the last meeting of the year on December 19th. However, both the Bank of Japan and the Japanese government are likely to want to raise rates only very slowly from here, partly because any more aggressive move could trigger further exchange rate volatility. Raising rates back to normal, after a generation of monetary ease, will likely prove to be a delicate operation.
Four Banks and the Dollar
There is a lot more than can be said and probably should be said about foreign central banks and their potential to impact the dollar. The Canadian dollar, the Mexican Peso and the Chinese Yuan are all important as currencies of major trading partners while others such as the Swiss Franc, the Brazilian Real and the Indian Rupee are important from an investment perspective.
However, just looking at the euro, the British pound and the yen underscores the difficulty in forecasting a steady dollar decline.
From here, it looks like the Fed will take its time in cutting rates back to normal. Meanwhile, both the ECB and the Bank of England could well cut more over the next two years than the U.S. The Japanese, who had been expected to normalize by raising rates, now look like they will do so very slowly. In short, prospects have faded for any narrowing in the gap between high U.S. rates and lower rates overseas. Moreover, while equity valuations are very low in the eurozone the U.K and Japan relative to the United States, none of these economies seem set to experience rapid economic growth. None of this suggests a near-term dollar decline.
Investing overseas does make sense, if only to reduce exposure to a now very highly valued U.S. dollar and U.S. equity market. However, those waiting for a dollar slump to amplify the return on their international investments, may still have to wait a little longer.