The Fed last Wednesday kept its benchmark interest rates unchanged at the record-low level of near zero. But Fed officials' latest dot-plot projections showed that the central bank may shift to two rate hikes in 2023, more hawkish relative to market expectations.
As a result, the U.S. dollar rallied, with the dollar index, which measures the greenback against six major peers, climbing to a two-month high of 92.2262 last Friday.
While the greenback dropped a little bit earlier this week, it inched higher on Wednesday and remained above the level where it traded before Fed officials' dot-plot projections were released last week.
"The spike in the dollar has been noteworthy, but in our view, is likely to be temporary and we maintain our view for a softer U.S. dollar over the medium-to-long term," Brendan McKenna and Nick Bennenbroek, economists at Wells Fargo Securities, said in a recent analysis.
Part of the reason is that actual monetary policy settings in the United States remain unchanged, while other central banks across the Group of 10 (G10) major economies have already taken and will likely continue to take more concrete steps to tighten monetary policy, they noted.
St. Louis Federal Reserve Bank President James Bullard said last week that he expected the Fed's first rate hike to come in late 2022, signaling the central bank might tighten monetary policy earlier than expected.
But Fed Chair Jerome Powell on Tuesday reassured markets that the central bank will be patient in its ultra-loose monetary policy, saying the Fed will not raise interest rates preemptively based on inflation fears.
"We will not raise interest rates preemptively because we think employment is too high, because we fear the possible onset of inflation. Instead, we will wait for actual evidence of actual inflation or other imbalances," Powell told lawmakers at a hearing before the House Select Subcommittee on the Coronavirus Crisis.
New York Federal Reserve Bank President John Williams also said on Tuesday that a discussion about raising interest rates is "still way off in the future."
The U.S. economy is still not close to meet the conditions of "substantial further progress" that the Fed laid out for tapering its asset purchase program, Williams said in an interview with Bloomberg Television.
Analysts at Goldman Sachs said they do not see a case for sustained dollar appreciation, as the firm forecasts only one rate hike by the end of 2023, more dovish than current market pricing.
Besides the Fed's patience, McKenna and Bennenbroek believed that a backdrop of global synchronized recovery from the COVID-19 pandemic should result in a weaker U.S. dollar over time.
"As foreign economies demonstrate resilience, or in some cases outperformance, and with the U.S. economy still strong, a backdrop of synchronized growth within the G10 should fuel positive sentiment toward foreign currencies and push the dollar lower," they argued, adding previous synchronized growth had resulted in a weaker greenback over the course of 2017.
"As the post-COVID recovery becomes more engrained, we believe those dynamics will repeat themselves and the U.S. dollar will gradually depreciate against G10 and emerging market currencies over time," they said.
The International Monetary Fund (IMF) in April projected that the global economy will grow by 6 percent in 2021, following an estimated historic contraction of 3.3 percent in 2020.
Advanced economies will expand by 5.1 percent this year, while emerging market and developing economies will grow 6.7 percent, according to the IMF.
Tiffany Wilding, an economist at PIMCO, a global investment management firm, said she expected to find good opportunities in emerging market local and external bonds, as well as select emerging market currencies.
"This reflects a combination of the forecast for ongoing global expansion (with the currencies of small, open economies poised to benefit from the ongoing cyclical upswing), valuations, and the Fed's very patient approach compared with its history and the potential for somewhat faster policy tightening elsewhere," Wilding wrote Wednesday in a report.
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