The main event of the trading week is the Federal Reserve’s decision on Wednesday. While the market participants do not expect the Fed to increase the pace of the quantitative easing program this week, the focus will be on finding out more details about the average inflation targeting.
The Fed altered its mandate lately and now focuses more on inflation rather than on the employment component. More precisely, it targets now average inflation at the 2% level. Like any average, it is important how long is the period considered – a few months or years? The difference is especially important because the more the Fed looks back in the past, the more easing lies ahead. Hence, the USD will react in anticipation.
Lower for Longer
The Fed reviewed its mandate, and the average inflation targeting regime comes with a truly clear message – lower rates for longer. But to achieve its new mandate of creating average inflation around the 2% level, the Fed will need to ease conditions even more than it did so far.
This can only translate into a weaker dollar and higher stock market prices, with not even one hint that the trend may change sometimes in the future. But how can the Fed still ease when it is already involved in quantitative easing and balance sheet expansion?
It seems that the new Fed will focus on easing the financial conditions on an ongoing basis. In other words, the effects of the Fed’s actions will be seen on a weaker USD, higher stock market prices, and tight credit spreads. All three must coexist at the same time for the financial conditions in the United States to ease.
For instance, from 2018 until 2020, the EURUSD rate declined from 1.25 to 1.06. Effectively, it meant a higher USD on the most important exchange rate.
However, at the same time, the U.S. equities moved higher as well. The stock market indices were at all-time highs, despite the fact that the USD gained ground. Such a situation will not be tolerated anymore by the new Fed. For financial conditions to ease on an ongoing basis, the Fed will make sure that all three conditions are satisfied – weak dollar, higher stock market prices, tight credit spreads.
For the market, this is a strong message. It means that even the slightest correction in the stock market may cause the Fed to deliver more easing.