FRB normalization, delta variant concerns caused dollar to appreciate since June
By Stephen Lee
Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Stephen Lee
The DXY (U.S. dollar index) ― measuring the value of the U.S. dollar against six major currencies ― stands at 92.89 as of July 21, its highest since April. The dollar depreciated in the 2nd quarter, on expectations that a global recovery would take place alongside a faster vaccination push. But the dollar has been rising again since June, this time on expectations that monetary policy will diverge between the Federal Reserve (FRB) and the European Central Bank (ECB), and concerns that a resurgence of COVID-19 will hurt the economic recovery.
Market participants have started to believe that the Fed is ahead of the ECB in terms of monetary policy normalization, as they believe that the dollar will be scarce in the future. In the June Federal Open Market Committee (FOMC) meeting, members started to pencil in mid-2023 as the appropriate time for policy firming. This move contrasts with their previous view in March that the Federal Funds Rate should stay near zero until the end of 2023. Unlike the Fed’s likely shift to earlier normalization, the ECB seems to stand where it was in March ― stating that the pace of PEPP purchases in 3Q21 will still be significantly higher than in the first months of this year.
The resurgence of COVID-19, triggered by the surging Delta variant, is also causing woes that economic recovery will reverse its course. Previous COVID-19 waves have resulted in lockdowns and restraints in mobility, causing economic growth to slow. The U.S. dollar serves as a safe haven. Therefore, in the case of any occurrence of counter-cyclical events, the value of the dollar tends to rise.
Three questions about factors affecting dollar
Will the dollar continue to rise? To answer this question, we need to ask ourselves three questions. These questions are: 1. What are governments doing to deal with the virus, 2. Are the delta variant and government measures affecting economic activities? and 3. Would any change in activities trigger a shift in the course of the Fed’s and ECB’s monetary policies?
Government measures: Empirical data from the U.S. and Spain shows that unvaccinated people are more vulnerable to the Delta variant. In the U.S., states with lower vaccination rates vis-a-vis the national average (55.8% as of July 12) are now experiencing rising COVID-19 cases. Some of the states include Arkansas, Louisiana and Mississippi, where vaccination rates are still below 45%. In Spain, the 10-29 age group is the most exposed to the Delta variant. Given this situation, governments with ample vaccines are planning booster jabs or are encouraging people to get vaccinated urgently. This policy direction is different from applying a 2020-style lockdown or emphasizing social distancing measures.
Economic activities: High frequency data is the most efficient gauge of the trend of economic activities, as official indicators tend to lag by a month or two. The OECD’s weekly tracker of economic activities, as well as Google Mobility Trends on Retail & Recreation in the U.S. and Europe, both suggest that actual economy activity has not been hurt yet. This situation may be the case because governments are generally refraining from applying lockdowns this time around.
Monetary policy and FX: Monetary policies are unlikely to be affected, if there appear to be no significant changes in economic activities. In our baseline view, the Fed will start tapering its pace of asset purchases in the first quarter of 2022, after announcing it in the September FOMC. The ECB will also start trimming its pace of PEPP purchases as early as its September meeting, because slowing the pace of asset purchases can allow for the same degree of accommodation amid economic recovery, and a higher natural rate. If this situation turns out to be the actual case, monetary policy divergence between the two central banks will ease in a couple of months, with limited impacts from the delta variant on the economy. This situation will likely see the US dollar depreciate against major currencies.
Risks to the outlook
Of course there are risks to such an outlook, as predicting with certainty the evolution of the virus and the human response is not possible. One risk that affects mobility is voluntary social distancing. The IMF has already mentioned this fact in their October 2020 World Economic Outlook. It states that voluntary distancing in advanced economies has a greater adverse impact (-10.6%) on mobility than lockdown stringency (-8.1%) for the first 90 days of each country’s epidemic. As recent new COVID-19 cases are rising faster in Europe than in the U.S., it is more likely that voluntary distancing will take place in Europe. If this voluntary distancing affects economic activity, monetary policy and the U.S. dollar will also be affected.
I would like to conclude by suggesting two different alternative scenarios below.
Scenario 1. If economic growth momentum continues in the U.S. while it slows in Europe, the ECB may delay policy normalization by a quarter or two. In contrast, the Fed will proceed with its original schedule. This situation implies that the Delta variant has both affected the economic activities and monetary policy divergence between the two central banks. The dollar will stay elevated for the next few quarters in this case.
Scenario 2. Similar growth divergence occurs, but this time, the Fed also delays the timeline for tapering based on concerns of a negative spillover effect as in 2016. In this latter case, the Delta variant did affect economic activities but did not cause a monetary policy divergence. The dollar will stay elevated but at a shorter horizon than in the former scenario.
The writer is the chief economist at Meritz Securities, Seoul.