The U.S. Federal Reserve and the European Central Bank (ECB) are faced with opposite policy problems that will exert a greater and greater influence over the forex market in the next several months.
I expect the different stances of these two central banks to push the euro/dollar out of its recent trading range on the downside.
First let's take the Fed. The big debate at the Fed's March meeting, according to the minutes released in mid-April, was whether to "taper off" quantitative easing (QE) or not. Then the statement from the April meeting shifted the debate to the left when it said "the committee [Federal Open Market Committee] is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation…" The question became not whether to taper off or not, but whether to loosen further or to taper off.
But as usual the FOMC's statement also said that it would continue with QE "until the outlook for the labor market has improved substantially." That adds another question for the Fed: how do you define "substantial?" The April nonfarm payrolls data showed jobs have been rising an average of 200,000 jobs a month over the last seven months, versus only 130,000 a month as recently as last September. Does this qualify as "substantial"? Jeffrey Lacker certainly thinks it does.
Lacker, president of the Federal Reserve Bank of Richmond, Virginia, said about the figures, "I don't think there is any question...that we've seen substantial improvement in the labor market outlook over the last 6 months." Note the use of the phrase "substantial improvement." And just in case you missed the point, he added, "I think you ought to evaluate the likelihood of us reducing the pace of asset purchases accordingly."
Monthly Change in Non-Farm Payrolls
Lacker is known as among the most hawkish members of the FOMC, but even Chicago Federal Reserve Bank President Charles Evans, one of the more dovish members, said back in October that the FOMC is likely to "continue with those asset purchases until we see payroll employment [growth] more like 200,000 or 250,000." So we're already in territory that even this dove has previously identified as a "substantial improvement" that qualifies for tapering off QE.
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Meanwhile, the ECB is in the exact opposite situation. The ECB has a single mandate – keeping inflation "close to but below 2 percent." Up to now it's been focused on the "below" part of that mandate, but as inflation falls and falls, they have to start focusing on the "close to" part – that is, making sure that inflation isn't too far below their target.
Core inflation hasn't been above the 2 percent danger line in 10 years and is now just 1 percent, half the ECB target level. The ECB forecasts headline inflation will average 1.6 percent this year, down from 2.5 percent last year, and will fall further to 1.3 percent next year. Yet it's currently estimated at around 1.2 percent.
Euro Zone Inflation
One difficulty for the ECB though is that unlike the other major central banks, it can't embark on QE. The problem is under normal conditions, the ECB is forbidden from buying the bonds of any of the individual euro zone countries so that it doesn't give an unfair funding advantage to one country over another.
Instead, when it wants to supply funds to the banking system it lends money directly to the banks. At its latest meeting it cut its main lending rate by 25 basis points. Moreover – and this is important - ECB President Mario Draghi said that the ECB stood ready to act again if needed.
That's ominous, because what more can they do? Cutting the ECB's main policy rate, the refinancing rate, another notch from the current 0.5 percent would just be a symbolic move that wouldn't have much effect on anything. But cutting the deposit rate – the rate that the ECB pays to banks when they deposit their excess money with the ECB - would have a big effect.
The deposit rate is currently zero. If it were negative, then banks might be more willing to lend out their excess money (since it would cost them something to hold the 120 billion euros or so in surplus funds that they currently have) and the flow of credit might increase. Or banks would simply avoid holding those excess euros, for example, by selling them into the forex market.
(Read More: Why the ECB Is 'Stupid' Europe's Best Hope)
Draghi said "we will look at this with an open mind" and said that there were no technical impediments to a negative interest rate.
Negative rates would be controversial. The move would cost banks money when many are struggling to stay afloat and boost their capital. Nonetheless, there is a precedent: Denmark instituted negative deposit rates last July. The rate cuts have been successful in weakening the currency. That's what I think would happen to the euro if they instituted negative deposit rates.
Two central banks with opposite problems. One central bank is going to face the question of whether it's time to back off from its extraordinary easing measures. The other central bank is facing the problem of whether to begin more extraordinary easing measures. I think that as the labor market continues to improve in the U.S. and the inflation rate continues to fall in Europe, this difference in policy will exert a bigger and bigger influence on the forex market and euro/dollar is likely to decline.
The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.