The dollar index (DXY) overshot its more than one year 96.00-100.00 range, propelled by the Federal Open Market Committee’s (FOMC) hawkish hold on June 17. We see scope for DXY to edge a bit higher in the coming months.

Interest rate differentials between the US and other major economies are consistent with DXY trading closer to 102.00 and US economic outperformance should keep the dollar supported (Chart 1). The Atlanta Fed GDPNow model estimates above trend annualized US real GDP growth of 3.0% in Q2 vs. 1.6% in Q1 while the May PMI data points to a widening US growth edge over peers (Chart 2).

Longer term, we remain bearish on the dollar because of protectionist US trade policy and worsening US fiscal credibility.

Protectionist trade policy

The Trump administration’s effort to narrow the US trade deficit means fewer dollars will flow overseas, reducing the need for those funds to be recycled back into US securities (Chart 3). That’s pure balance of payments mechanics and is a structural drag on the dollar.

Worsening fiscal credibility

The rise in the US Treasury term premium alongside rapidly increasing debt services costs suggests investors are demanding greater compensation to hold long dated Treasuries (Chart 4). Over time, a widening fiscal risk premium could erode the dollar’s appeal as the world’s primary reserve currency by raising questions about the long-term sustainability of US public finances.

Hawk and Awe

The FOMC delivered a hawkish hold on June 17. As was widely expected, the FOMC left the target range for the funds rate unchanged at 3.50%-3.75% for a fourth straight meeting. The decision was unanimous, and the FOMC statement scrapped its implicit easing bias.

It was a hawkish hold largely because of the swing in the median Fed funds rate projection from a cut to a hike by year-end. Additionally, Fed Chair Kevin Warsh’s unwavering commitment to the Fed’s 2% inflation target, suggested a higher-for-longer policy bias given that the underlying disinflationary trend has stalled (Chart 5). As a result, Fed funds rate hike bets surged to imply greater odds for 50bps of tightening by year end.

Beyond the hawkish hold, three other themes stood out:

1) A shift toward strategic ambiguity. That was underscored by Warsh not submitting his “dot plots” for the Summary of Economic Projections. Less explicit forward guidance means markets must infer both the direction and magnitude of policy changes from incoming data.

Whereas under forward guidance, the Fed signaled the direction of policy and markets mainly adjusted the magnitude of expected moves as data evolved. As such, strategic ambiguity will likely result in bigger swings to Fed funds futures especially around policy-relevant data releases.

2) A constructive US macro backdrop. The FOMC statement acknowledged the economy’s resilient demand-side backdrop noting that “economic activity is expanding at a solid pace,” but also emphasized the favorable supply-side condition, highlighting that “productivity growth and capital investment are strong.” That implies the economy can grow faster without generating inflation, reducing the need for restrictive monetary policy over the medium term.

3) The set up of five task forces to re-examine core functions of the central bank. Fed communications, the Fed’s balance sheet, the use and reliance on existing data sources, productivity and jobs in an era of transformation, and the Fed’s inflation frameworks.

The results of the task forces are expected at the latest by year-end. Given Warsh’s view on productivity, inflation, and the Fed’s balance sheet, the result could steer the FOMC in a more dovish direction.

Productivity

Warsh expects the productivity boost from artificial intelligence (AI) to justify lower interest rates, noting “AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness.¹”

During the current business cycle, starting in Q4 2019, labor productivity has grown at an annualized rate of 2.1%. As such, productivity is running strong enough to keep the roughly 4% annual wage growth consistent with the Fed’s 2% target (Chart 6).²

Inflation

Warsh said he preferred to follow “trimmed averages” inflation as opposed to core price index for personal consumption expenditures (PCE). The Dallas Fed trimmed mean PCE and the Cleveland Fed 16% trimmed mean CPI are currently below core PCE, implying room for the Fed to loosen policy (Chart 7).

Fed balance sheet

Warsh favors slashing the Fed’s balance sheet to create scope for rate cuts (Chart 8). According to Warsh, “The Fed’s bloated balance sheet…can be reduced significantly. That largesse can be redeployed in the form of lower interest rates to support households and small and medium-size businesses.” He has also noted “the interest rate tool gets in the cracks. It’s fairer. The balance sheet tool disproportionately helps those with financial assets."³

The constraints

Kevin Warsh faces two major constraints that could disappoint markets expecting a more dovish Fed tilt.

1. FOMC is not a one man show. Warsh cannot simply dictate policy, which is made collectively by 12 voting members; 7 members of the Board of Governors, the president of the New York Fed, and 4 of the remaining 11 regional Fed presidents, who vote on a rotating basis. Non-voting regional Fed presidents still participate in discussions and can also influence the debate.

The risk is if Jerome Powell leaves the Board of Governors before his term ends January 31, 2028. If so, President Trump would have the opportunity to strengthen his influence over the Fed by appointing a new governor more aligned with his unorthodox monetary policy view, like Stephen Miran. That would give Trump appointed governors a 4-3 majority on the seven-member Board (Chart 9). While this would not guarantee a shift in monetary policy, the perception of increased political influence over the Fed could undermine its inflation fighting credibility.

2. Funding market stress risk limits the Fed’s ability to reduce the balance sheet. To shrink the Fed’s balance sheet in a significant way would involve reducing reserve demand. Reserves are the funds that depository institutions hold in accounts at the Fed. They are the safest and most liquid asset in the financial system and give banks greater scope to settle payments in an orderly way.

Reserve balances make up the bulk of the Fed’s liabilities and are directly controlled by the Fed (Chart 10). By contrast, the other two big liabilities on the balance sheet, currency outstanding and the Treasury General Account (TGA), are outside the Fed’s control.

Reserves currently represent $3.1 trillion of the Fed’s $6.7 trillion in liabilities (about 10% of GDP). Before the 2008 global financial crisis, reserves totaled just $17 billion of the Fed’s $890 billion in liabilities. The surge in reserves reflects the Fed’s large scale asset purchases (quantitative easing), the Fed’s shift from a scarce to an ample reserve system to control short-term interest rates, and tighter bank liquidity regulations.

Reserve balances are comfortably above levels the Fed judges consistent with adequate reserves, estimated to be around 9% of GDP or $2.7 trillion. The risk of operating at lower levels of reserves is that liquidity conditions can tighten abruptly as banks become less willing to lend reserves into funding markets to preserve liquidity buffers. That raises the risk of spikes to short-term market rates and heightened volatility, as seen during the September 2019 repurchase agreement (repo) crisis when reserves fell below 7% of GDP.

Bottom line

The FOMC consensus driven structure and reserve-scarcity risks constrain the scope for a straightforward dovish regime shift under Warsh. In parallel, the retreat from forward guidance is likely to produce larger volatility in rates, the dollar, and risk assets as markets recalibrate after each major data release.