Accelerated QE tapering and a fast-growing economy support highly optimistic USD forecasts in 2022. Confidence in the US dollar is building up as healthy economic expansion and soaring inflation are bringing the Fed’s bond purchases to an end in March. However, the dollar’s fate is still hanging on the Covid situation as the Omicron variant is still adding uncertainty to the economic outlook and posing threat to global recovery.
First, let’s recap how the USD performed through 2021.
US Dollar Performance in 2021
The USD started the year on a weak note, sliding against major rivals as uncertainty resulted in a gloomy economic outlook. Soon after, the dollar quickly began to win back losses and the single currency encountered notable losses against the greenback, falling to a two-and-a-half-year low and hitting a YTD low of 1.17 by the end of Q1 as the EUR got burdened by a second lockdown that crippled the area’s economic recovery.
The second quarter, however, witnessed a weaker USD performance due to rising risk appetite that dragged the dollar into new lows. Meanwhile, EUR/USD rebounded off $1.17 towards $1.23 in May, before weakening again to $1.19 in June and $1.12 in November.
US dollar index (DXY), which measures the value of the currency against a basket of six major currencies, was up by nearly 7% in 2021, the biggest annual gain in 6 years. The solid US economic growth and high inflation outpaced the rising uncertainty caused by the COVID-19 concerns.
An Overview of U.S. Economic Activity
Annual inflation rate hit 7% in December 2021, the highest level since the 1980s. Energy was the top contributor as gasoline prices accelerated by nearly 50%. Rising energy costs, pandemic supply constraints and labor shortages are among the major factors behind soaring price inflation during last year, proving the Fed wrong about “transitory” inflationary pressures. Inflation now sets 5% higher than Fed’s targeted rate at 2%.
With oil prices now trading at seven-year highs, stronger demand and restrained output, prices outlook seems promising. Higher energy prices would keep inflation rising, unless the central bank steps in. The Fed pledged to take the necessary action to curb inflationary pressures, including rising interest rates.
The job market had an impressive recovery from 2020’s pandemic hit, retrieving 83% of pandemic-era lost jobs. US employment has increased by 18.8 million since April 2020, but is still down 2.3%, or 3.6 million, from its pre-pandemic levels in early 2020. Meanwhile, the unemployment rate declined to 3.9%. In 2021, average hourly earnings have increased by 4.7%.
The only source of concern seems to be the participation rate, which still hovers below its pre-pandemic levels at 61.8%.
The Federal Reserve adopts a dual mandate policy; price stability and employment. To achieve policy mandates, the bank utilizes monetary tools including interest rates, inflation levels, money supply, lending to commercial banks, and reserve requirements.
Despite accelerating inflation, the economic recovery was steady in H1 backed by increase in vaccination rates and governmental aid. However, growth dramatically slowed down in the third quarter fueling stagflation fears. The economy grew by an annualized on quarter rate of 2.3% in Q3, following a 6.7% expansion in the second quarter. Growth for the 4th quarter is yet to be released, and the economic growth is expected to accelerate in the October-December quarter, on track to its biggest expansion in almost 40 years.
The Stock Market
The stock market was on the uptrend most of the year, and it seemed to be unstoppable. High inflation and growing expectations for a rate hike series failed to halt stocks. S&P 500 climbed to a new record high at 4,766 in December 2021, recording 70 closing highs in 2021, according to S&P Global. Meanwhile, the Dow Jones Industrial Average hit new highs, up by 18.7% throughout the year. The Nasdaq Composite climbed 21.4%.
The Fed and Monetary Policy
The Federal Reserve announced in December an accelerated exit from the bond-buying program, bringing the QE to an end in March 2022. Net asset purchases to be reduced by $20bn for Treasury securities and $10bn for agency mortgage-backed securities per month beginning in January. The FOMC also signaled its willingness to hike interest rates at a faster pace. December’s dot plot revealed that board members are expecting 3 rate hikes in 2022.
Despite the hawkish approach, investors are still skeptical about the policy outlook. That seemed obvious as the stock market cheered recent hawkish announcements and the bond market was muted.
The Fed stated that policy moves will depend on the inflation case, which seemed more dovish than hawkish. The bank foresees inflation around 2.5% for the next few years. The tightening approach really comes amid persistent inflationary pressures. The Fed seems to believe that supply and demand imbalances are the main driver of high inflation. However, there are more factors contributing to higher inflation including rising home prices by 19%, higher wages and rising energy prices.
What’s Next for USD?
USD forecasts are promising and greenback is posed for more gains in 2022, thanks to the Fed’s tightening bias and solid economic performance. The GDP growth is projected at 5% this year. The main risks to the positive USD outlook are the Covid-19 updates and stagflation fears.
However, many currencies are projected to underperform against the US dollar in 2022. This is due to the fact that the Federal Reserve, unlike most central banks, has actively stepped into policy tightening. Us interest rates are expected to rise to at least 1.5% by the end of 2023.
2022 is expected to be another disappointing year for the EUR/USD. Policy divergence between Fed and ECB will likely remain the main driver for more losses this year. Despite growing speculations that the ECB is finally ready to conclude its Pandemic Emergency Purchase Program (PEPP) in March, the bank announced its willingness to temporarily expand the longer running Asset Purchase Program (APP) in Q2. Seems like the Eurozone will be stuck with lower rates and QE for longer.
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