Fed Preview: Powell to send the dollar back down with dovish hike, message of uncertainty

• The Federal Reserve is set to raise interest rates for the first time since the pandemic.

• Bank's "dot plot" may fall short of markets' aggressive expectations. 

• Fed Chair Powell's message of uncertainty given the war could also weigh on the dollar.

High inflation means aggressive rate hikes – investors foresee an increase in borrowing costs by the Federal Reserve at every meeting this year, a dollar-positive outcome. The bank may have other plans, grinding the greenback lower.

Fed Chair Jerome Powell has already stated that he will oversee an increase of 25 bps in the Federal Funds Rate in this upcoming March meeting, the first tightening in the covid era. The move comes just as the world's most powerful central bank concludes its bond-buying scheme. It also comes amid rising inflation:

Source: FXStreet

The headline US Consumer Price Index hit 7.9% YoY in February, the highest in over 40 years. While the price at the pump is the most visible reminder that costs are rising, Core CPI has also gone up, hitting 6.4% annually last month. That is substantially above the Fed's 2% target. 

The bank's second mandate is full employment, where the picture is also upbeat. America suffers from a labor shortage, not unemployment, as the latest data have shown – no fewer than 678,000 new hirings in February, an increase that pushed the jobless rate down to 3.8% despite widening participation. 

US unemployment is back to pre-pandemic levels

Source: FXStreet

Market expectations

Before Powell clarified that the Fed is set to hike by 25 bps, officials flirted with the option of a non-standard, double-dose hike of 50 bps. His words were enough to shift expectations back to the standard 25 bps increase. 

While bond markets no longer price such an option for March, they see the Washington-based institution increase borrowing costs at every meeting, ending 2022 with a total of seven 25 bps increases and an FFR ranging between 1.75% and 2.00%.

Source: CME Group

This hawkish view is justified by persistently high inflation and the Fed's openness to raising rates by 50 bps increments if needed. Investors will be looking to the bank's forecasts for interest rates – aka "the dot plot" – for clues about the next moves. They could be in for a dovish surprise.

In December, the Fed foresaw only three increases in 2022, which has likely risen. However, it would be a substantial leap of faith to expect seven increases this year. 

Apart from the statement and the forecasts released at 18:00 GMT, markets will be listening in to Chair Powell's press conference due at 18:30 GMT. While Powell could throw a bone to the hawks by leaving an open door to moving fast and bumping borrowing costs by 50 bps, it is essential to note that there is a war going on.

Russia's ongoing invasion of Ukraine and the West's sanctions are rocking the global economy. Uncertainty is high enough to cause consumers to pause, and higher prices – not only at the pump – could cause what economists call "demand destruction." Others say that "the cure to higher prices is higher prices" – elevated costs would already trigger less demand and an eventual fall in prices. 

Given the uncertainty about global demand, costs of oil, wheat, and several critical metals extracted in Russia, it would be prudent for Powell to strike a tone of caution in his messages over the next steps. European Central Bank President Christine Lagarde stressed the fact that forecasting is extremely difficult in these conditions, and there is no reason Powell would express certainty in the fog of war.

Signaling that the Fed may raise rates by less than markets project if the situation worsens may cause repricing in markets. It would serve as an opportunity for investors to unwind some of their long dollar positions, built up in response to the war, as funds flocked to the safety of the greenback.

For stocks, it would probably be a blessing. While worries about the war have been weighing on equities, a commitment from the Fed to provide support would boost sentiment – at least in the short term.

Final thoughts

The Fed will likely perform a "dovish hike" – raising rates and signaling more to come, but with a huge asterisk related to the war. Being open to all scenarios does not mean imminent 50 bps hikes, but rather willingness to pause if the US economy suffers. 

Regarding unwinding the bank's bloated balance sheet by selling assets, news on the front will likely wait for another day, leaving the focus on Powell's message.