Pound-to-Dollar Rate: The Fed's Push to Raise Interest Rates above "Neutral" is a Bitter Pill for the Dollar to Swallow

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- Federal Reserve policymakers eye neutral rate push in 2019/20.

- Rising rates to support USD in short term, but further down line.

- Rate support to abandon USD just as BoE picks up pace of hikes.

The Pound-to-Dollar rate could benefit from the Federal Reserve (Fed) push to raise its interest rate above the "neutral" level in the year ahead, because analysts are saying such a move will be a bitter pill for the U.S. greenback to swallow.

The "neutral" rate of interest is the equilibrium level at which rates themselves neither encourage nor restrict economic activity. It is not fixed at a particular point, policymakers do not know exactly where it is at any one point in time and so are left with little choice but to estimate where it might be. 

Minutes from September's Federal Reserve interest rate meeting revealed Wednesday that only "a couple" of the Federal Open Market Committee's 16 voting members are opposed to the idea that interest rates might need to be set temporarily above their "long run level" in the coming quarters. 

Federal Reserve projections released in September showed policymakers lifting their estimate of that "long run level" to 3%, from 2.9% back in June. They also confirmed Fed officials expect to raise rates to around 3.4% early in 2020, when the current cycle of policy tightening is seen coming to an end.

"The minutes reaffirmed that the Fed could hike above the neutral level," says Mark McCormick, North American head of FX strategy at TD Securities. "But as borrowing costs rise that will challenge that return on capital unless growth potential increases, leaving the [Dollar index] a fade towards the highs."

Wednesday's minutes detailing opposition to this view coming from only "a couple" of the Fed's board members have shown the market that the bar to raising rates that high is actually quite low. 

However, despite that another four or five hikes can be expected to provide support to the greenback over the coming year, the Dollar is unlikely to get any thanks from the market when rates draw near to the FOMC's projected levels.

This is because markets tend to "buy the rumour and sell the fact", which means that once an end to the Federal Reserve's rate hiking cycle is just around the corner, traders would be most likely to dump the Dollar anyway.

But rates moving above the so called neutral level would provide an added incentive to get shot of the U.S. currency, because such a move may lead the U.S. economy to slow. That will eventually command a reduction in U.S. interest rates. 

"The minutes suggest that policymakers, while aware that interest rates are no longer supporting growth much, are still likely to continue hiking at a gradual pace with the majority believing these hikes will take them slightly above the neutral rate," says Andrew Grantham, an economist at CIBC Capital Markets. 

The Fed has raised interest rates eight times since the end of 2015, including three times in 2018, taking the Fed Funds rate range to between 2% and 2.25%. Economists say it is likely to lift rates so the top end of that range hits 3.25% around the end of 2019. One further hike in 2020 would take it to 3.5%. 

Changes in interest rates are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators. Rising rates tend to lift their respective currencies and vice versa. 

"The Fed will persist with its "gradual approach" of hiking by 25bp each quarter. That is until mid-2019, when we expect a drop in GDP growth to below-potential to force the Fed to the sidelines," says Paul Ashworth, chief North American economist at Capital Economics. 

All of this matters for the Pound-to-Dollar rate because by the time January 2020 comes around, when an end of the Fed cycle is looming, the Bank of England is likely to have enough clarity on what the Brexit process means for growth to justify lifting its own interest rate a bit faster. Assuming the economy and inflation outlook still warrant such a move.  

That would begin to close the still-widening gap between interest rates on either side of the Atlantic ocean, providing a boost to the currently-beleaguered British currency while lifting the Pound-to-Dollar rate in the process. 

The Bank of England has already raised its interest rate twice inside the last year, to 0.75%, citing its own forecasts that show the consumer price index remaining above the 2% target until the first-quarter of 2021. And those forecasts already assume a steady pace of one hike per year in the interim. 

The Pound-to-Dollar rate was quoted 0.01% lower at 1.3099 Thursday and is down 2.94% for the 2018 year. It still 9.9% below the 1.4548 level is was trading at markets got wind of the outcome from the Brexit referendum that took place on June 23, 2016.

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