Chart of the Month
Among all the potential drivers of a bilateral exchange rate, the 2-year interest rate differential has been considered one of the most influential, alongside inflation and terms of trade differentials. The chart shows the relationship between the Euro/US$ exchange rate and 2-year German-US spread over the past 7 years. We can see that an interesting change occurred in late 2013 beginning of 2014, a period when the correlation between the two underlying assets was disturbed. The red line represents Draghi’s May 2014 ‘Ready to act’ speech, and the black line represents the start of the QE in March 2015. Policy innovations, including QE and forward guidance, have systematically weakened the importance of the interest rate differential.
Market prices of inflation compensation infer that participants are relaxed about the inflation outlook. Yet, a new index produced by the New York Fed called the UIG (underlying inflation gauge) suggests otherwise. It comes in two versions: “prices only” and “full data”. Both the comprehensive measure, which includes additional variables outside of prices including the unemployment rate, bond yields and PMIs, and the “prices only” version have shown “more accurate forecasts of inflation compared with core inflation measures” according to the NY Fed. These measures suggest that trend CPI inflation is in the 2.2 per cent to 2.7 per cent range, above the Federal Reserve’s 2 per cent objective. Yellen’s choice?
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