Dollar climbs on Fed tapering expectations, but delays could upend rise

Expectations of tighter U.S. monetary policy have pushed the dollar to highs on the year, but the greenback could stumble if Federal Reserve Chairman Jerome Powell delivers a dovish message later this month.

Fed officials have indicated that a tapering of its $120 billion in monthly bond purchases may soon be launched, boosting the possibility of an interest rate hike in 2022 and strengthening the dollar. But if Powell gives little insight into those tapering plans during his planned speech at the Fed's annual economic policy symposium later this month, or signals that tapering may be pushed further into next year, the dollar's recent rise may be quickly deflated.

"If Chair Powell disappoints market expectations in any way, say over the potential timing of the taper, or say the planned pace of tapering once underway, then it would help to ease upward pressure on the U.S. dollar in the near-term," said Lee Hardman, a currency economist at finance company MUFG.

The Dow Jones FXCM Dollar Index is up 2.4% on the year, and in July it jumped to its highest level since November 2020. The index, which measures the U.S. dollar against a basket of four currencies — the euro, British pound, Japanese yen and Australian dollar — has climbed steadily since the end of July as Fed officials have signaled that tapering could begin later this year.

"Currencies normally appreciate when their domestic short-term rates rise," said Francesco Pesole, a foreign exchange strategist with banking and financial services company ING. "As the Fed continues to signal imminent tightening, markets are pricing in higher rates in the U.S., which is offering support to the dollar amid an already generalized choppy risk environment that is a positive for the safe-haven dollar."

The euro closed at $1.17 on Aug. 10, matching its lowest close of the year.

"Traders are pricing in the potential for an earlier-than-previously anticipated announcement that the Federal Reserve may start tapering its asset purchases after a run of strong data out of the U.S.," said Matthew Weller, global head of market research with GAIN Capital.

On Aug. 6, the U.S. Bureau of Labor Statistics reported that the unemployment rate fell to 5.4% in July, down from 5.9% in June and 10.2% in July 2020. On Aug. 11, the bureau reported that its consumer price index, the market's preferred inflation measure, was up 5.4% year over year in July, matching June's increase.

In separate speeches this week, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, and Tom Barkin, president of the Federal Reserve Bank of Richmond, both said the Fed's 2% inflation goal had been met, indicating that a taper start may be imminent, according to press reports. Bostic forecast a start to that taper before the end of this year.

That inflation goal, along with a broad aim to reach maximum employment, have been outlined by Powell as conditions for a tightening of ultraloose monetary policy.

"If the Fed tightens policy sooner, that will tighten the supply of U.S. dollars and put upward pressure on U.S. rates, making the U.S. dollar more attractive," MFUG's Hardman said.