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Though U.S. Fed monetary policy decisions are intended to control domestic inflation and unemployment, they still affect international exchange rates.

How the Fed’s Monetary Policy Affects Exchange RatesARTICLE

By Frances Coppola

Since 1992, the U.S. dollar has floated freely against other major world currencies. The Federal Reserve (Fed) no longer directly manages the dollar’s exchange rate with any other currency, although some countries, such as China, fix or control their own currency’s exchange rate relative to the dollar. The Fed uses interest rate policy and, since 2008, direct management of the supply of dollars with “Quantitative Easing” (QE) and similar tools, to meet its “dual mandate” of price stability and low unemployment. International businesses have learned to live with – and in some cases, take advantage of – continual fluctuations in dollar exchange rates.

But although the Fed’s monetary policy decisions are intended to control domestic inflation and unemployment, they still affect international exchange rates. This is how it works.

How Interest Rate Policy Affects the U.S. Dollar’s Exchange Rates

When domestic inflation looks as if it is going to rise above the Fed’s target of 2 percent annually, the Fed can raise interest rates. This increases the cost of borrowing for U.S. firms and households, discouraging them from borrowing to spend. And for firms and households with floating rate loans, raising interest rates also reduces the amount of income they have left after paying existing creditors, which can force them to cut back spending. Thus, raising interest rates reduces spending (“demand”) in the economy. Firms respond to this by slowing price rises or even cutting prices. Inflation therefore falls.

That’s the effect of Fed monetary policy within the U.S. But internationally, the story is different. When the Fed raises interest rates, international investors see an opportunity to make better return on investment in dollars than other currencies, so they buy dollars and/or stocks and bonds denominated in dollars. This raises the international price of dollar-denominated assets, including the dollar itself. Thus, raising interest rates causes the dollar’s exchange rate to rise.

Conversely, if the Fed cuts interest rates to encourage firms and households to borrow and spend, international investors suffer a fall in their return on dollar-denominated assets, so they abandon them in favor of higher-yielding assets elsewhere. The dollar’s exchange rate therefore falls.

This is the simple, theoretical story. In practice, things are a little more complicated. Investors respond to signaling from the Fed – what is known as “forward guidance.”1 So, when the Fed signals that it could raise interest rates if the economy continues to improve, investors buy dollar-denominated assets, causing the dollar exchange rate to rise. Raising the dollar exchange rate dampens domestic demand, since imports become more expensive so households and firms are likely to cut back spending. Thus, Fed forward guidance can have a similar effect to actual interest rate rises.

For example, the first Fed interest rate rise in December 2016 was so heavily signaled in advance2 that the rise was “priced into the market” long before it occurred, causing the dollar exchange rate to rise significantly well in advance of the rate rise.3 This was a mixed blessing: signaling the rate rise in advance avoided a “taper tantrum” like that in May 2013,4 but made it impossible for the Fed to change its mind about the rate rise without causing market disruption, even though “personal consumption expenditures” (PCE) inflation (the Fed’s preferred measure) was some distance below the Fed’s 2 percent target.5

How QE Affects Currency Exchange Rates

When the Fed started its first round of QE in 2008, it was widely believed that it would work primarily by encouraging banks to lend. The Fed bought enormous amounts of assets (mainly U.S. Treasuries and agency mortgage-backed securities) from banks and investors, paying them newly created dollars in return. With such an enormous inflow of deposits, it was thought, banks would have to lend far more to businesses and households, thus increasing spending and investment in the economy.

In fact, banks were so damaged after the financial crisis that they were neither able nor willing to increase lending. More importantly, we now know that banks don’t “lend out” deposits, so increasing their stock of deposits does not force them to lend.6

So how does QE work? Lord Adair Turner, former head of the U.K.’s Financial Services Authority, says that QE works through three channels:

  • It caps the cost of government borrowing, allowing governments to increase spending at low cost.
  • It raises asset prices, increasing household and corporate wealth and thus encouraging spending through “wealth effects” (which simply means that when people feel richer, they are likely to spend more).
  • It depresses the currency exchange rate, thus encouraging exports and discouraging imports.7

As with interest rates, simply announcing QE (or signaling that it is being considered) can be sufficient to affect exchange rates. For example, dollar exchange rates, along with other asset prices, jumped in May 2013 when the Fed unexpectedly announced that it was considering tapering off its QE program.8

The exchange rate effects of QE are similar for other central banks. Research from the Bank of England shows that announcing its first round of QE in 2009 caused a fall of 4 percent in sterling’s exchange rate index.9 And in Europe, the euro’s exchange rate rose in June 2017 when Mario Draghi, President of the European Central Bank (ECB), signaled the possibility of an end to QE.10

How the Fed’s Monetary Policy Affects International Exchange Rates

The Fed’s monetary policy decisions don’t just affect the U.S. dollar’s exchange rate. Because assets traded on global markets are priced in dollars, other currency exchange rates can also be affected, particularly those of oil and commodity exporters. For example, the end of the Fed’s QE program caused a significant fall in the Australian dollar’s exchange rate. Of course, all currency exchange rates were falling against the U.S. dollar at that time. But the Australian dollar’s exchange rate fell more than some other currencies.

This is because Australia is a major exporter of iron ore. The Australian dollar’s exchange rate is sensitive to movements in the global price of iron ore. The tapering of the Fed’s QE program in 2014, and associated soaring U.S. dollar exchange rate, triggered major falls in oil and commodity prices.11 As the price of Australia’s primary export fell, the Australian dollar’s exchange rate dropped substantially in relation to all other currencies – not just the U.S. dollar.12

The Takeaway

The Fed’s monetary policy is not primarily intended to manage the U.S. dollar’s exchange rate. Its purpose is to keep inflation and unemployment in the U.S. low and stable. However, because the U.S. dollar is the world’s premier reserve currency and floats freely against other currencies, Fed monetary policy operations have international effects. International businesses therefore might find it helpful to keep an eye on the signals given by the Fed when planning their FX risk management strategy.

The Author

Debra Donston-Miller

Debra Donston-Miller is a veteran journalist, specializing in IT, business, career and education content. Formerly editor of eWEEK magazine and content director of eWEEK Labs, Donston-Miller currently develops content and content strategy for multiple organizations.

Sources

1. “U.S Relations with Australia,” U.S. Department of State; https://www.state.gov/r/pa/ei/bgn/2698.htm
2. Ibid
3. “Australia Matters for America: U.S.-Australia Imports and Exports,” East-West Center; http://www.asiamattersforamerica.org/australia/data/trade/importexport
4. Ibid
5. Doing Business in Australia: Essential Tax, Compliance and Reporting Considerations, EY; http://www.ey.com/Publication/vwLUAssets/Doing_Business_in_Australia_and_Australian_tax_landscape/$FILE/EY-doing-business-guide-australia.pdf
6. Ibid
7. “Invest in Australia: Guide to Investing,” Australian Trade and Investment Commission; https://www.austrade.gov.au/International/Invest/Guide-to-investing/Setting-up-a-business
8. Ibid
9. Doing Business in Australia: Essential Tax, Compliance and Reporting Considerations, EY; http://www.ey.com/Publication/vwLUAssets/Doing_Business_in_Australia_and_Australian_tax_landscape/$FILE/EY-doing-business-guide-australia.pdf
10. “Foreign Companies,” Australian Trade and Investment Commission; http://asic.gov.au/for-business/registering-a-company/steps-to-register-a-company/foreign-companies/
11. Ibid
12. Ibid
13. “Australian Workplace Culture,” Career Workforce Development Center; www.skills.sa.gov.au/dmx?Command=Core_Download&EntryId=1201
14. Ibid
15. “Guide to Australia: Etiquette, Culture, Customs & Business; Kwintessential; http://www.kwintessential.co.uk/resources/guides/guide-to-australia-etiquette-customs-culture-business/
16. Australian Workplace Culture,” Career Workforce Development Center; www.skills.sa.gov.au/dmx?Command=Core_Download&EntryId=1201
17. “Guide to Australia: Etiquette, Culture, Customs & Business; Kwintessential; http://www.kwintessential.co.uk/resources/guides/guide-to-australia-etiquette-customs-culture-business/

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