Currency markets react to US tapering

The US dollar (USD) has been relatively strong since mid December 2013, at least compared to other currencies.

During this time period, the US Federal Reserve (the Fed) announced its tapering effort, and the new Fed chair, Janet Yellen confirmed the strategy would continue.

In response to the Fed’s fiscal actions and forward guidance, the USD reacted with a positive positioning in many currency pairs. The appreciation of the USD against other currencies was slowed somewhat by market concerns around inflation and employment data in the US. But central banks in other countries took action to lower their own currencies, causing excessive fluctuation in many currency pairs.

When an opposite currency—in this case the USD—is appreciating within the pair, the other central bank has more leverage to lower its own currency. By doing so, the bank can positively influence its countries’ exports, improve the balance of its current account, and increase inflation. Boosting inflation is important for many central banks during times when disinflation is a problem.

Lowering the currency has short and long term goals. Central banks know their countries’ exporters need time to respond to a lower currency exchange rate. Therefore, they don’t expect a sudden increase in exports. But central banks also know importers will have to “build in” currency exchange losses into their prices—stimulating the country’s inflation.

Some central banks can’t depreciate their currency due to previous fiscal efforts or the poor shape of their country’s economy.

It’s worth noting the USD should have appreciated even more in response to the Fed’s actions but the stronger positioning would have been in conflict with US currency intentions and negatively affected developing nations. The current Fed chair’s sensitive approach to tapering is consistent with US internal and external economical objectives.

Now and in the near term, a lower-value USD is beneficial for the US economy and overall currency market stability. It will be interesting to observe the implementation of “somehow lower USD” monetary policy in the fiscal environment of tapering. It will definitely cause more currency fluctuations in the future.

Darek Wozniak is president of JW Investrade, a currency exchange consulting firm in London, Ont. He may be reached via email.