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Sudden Fed Decision To Halt Interest Rate Rises Could Mean Weaker Dollar Exchange Rate

By Frances Coppola

The Federal Reserve has put the brakes on interest rate rises. And it did so even though it raised interest rates four times in 2018—a year in which the dollar’s exchange rate was extremely strong—and in December had signaled further interest rate rises for 2019.1,2

But in its most recent monetary policy announcement, the Fed left rates unchanged and said it would be “patient” about when, or whether, there will be future rises.3 As interest rates and exchange rates tend to rise and fall together, the Fed’s decision could mean the end of the strong dollar—and raise questions about the implications for U.S. businesses in 2019.

 

How U.S. Interest Rates and Exchange Rates Influence Each Other

 

When the Fed raises interest rates, investors looking for returns tend to sell assets denominated in foreign currencies and buy dollar-denominated assets. The wider the spread between U.S. interest rates and interest rates in other countries, the more investors are likely to move from foreign-denominated to dollar-denominated assets. In order to purchase dollar-denominated assets, investors need dollars. So, they exchange other currencies for dollars, and their increased demand for dollars raises the dollar exchange rate. Conversely, when the Fed cuts interest rates, investors sell dollar-denominated assets and buy foreign assets, which tends to weaken the dollar’s exchange rate. Thus, U.S. interest rates and exchange rates tend to rise and fall in tandem.

 

The Fed’s interest rate decisions also influence the interest rate decisions of other central banks, but in the opposite direction. When the Fed raises rates, strengthening the dollar, the currency exchange rates of other countries tend to weaken. This raises the prices of imports to those countries, pushing up inflation. If imports are generally priced in U.S. dollars, as is typically the case for developing countries, a falling currency exchange rate can also make it difficult for companies and governments to service dollar-denominated debt. So central banks, particularly in developing countries, may decide to support their currency exchange rates by raising interest rates in parallel with the Fed to negate the effect of the Fed’s actions.

 

Conversely, when the Fed cuts interest rates, the currency exchange rates of other countries tend to strengthen, hampering their export businesses. Central banks in those countries may choose to cut interest rates in line with the Fed rather than accept weaker exports.

 

Thus, the Fed’s interest rate decisions affect the dollar’s exchange rate, and the dollar’s exchange rate can influence interest rate decisions in other countries.

 

Weaker USD Could Benefit International Businesses, Improve Global Trade

 

Rising interest rates have been driving the dollar exchange rate up for the past year. The strong dollar has worsened terms of trade for American exporters, which is reflected in a widening U.S. trade deficit. But perhaps more importantly, the rising cost of dollars for international businesses has negatively affected the global economy. Several developing countries have experienced FX crises due to the strong dollar, and in the fourth quarter of 2018 both China and the Eurozone weakened economically.4 The International Monetary Fund (IMF) says it expects global growth to slow in 2019.5

 

When the dollar’s exchange rate rises, banks can become reluctant to lend for trade finance because of the cost of funding in dollars. This can make it difficult for international businesses to access the working capital they need to pay foreign suppliers. As a result, they may shrink their supply chains and reduce their trade volumes. Additionally, a strong dollar may raise credit risks for American businesses with international customers. So, a rising dollar exchange rate can mean that global trade shrinks, with negative implications for global growth.

 

A weaker dollar can reduce international businesses’ credit risks and make dollar funding easier and cheaper to obtain. This can help them to expand internationally and develop their supply chains. A weaker dollar can also encourage investment in developing countries and improve the terms of trade of commodity exporters. All of this tends to increase both global trade and global economic growth.

 

So, if the Fed’s decision means a lower dollar exchange rate, this could be good news for U.S. businesses and for international trade.

 

But What Does the Sudden Fed Halt Mean for U.S. Businesses?

 

At the press conference after the announcement, the Fed’s chairman, Jerome Powell, cited several reasons for the decision:

 

  • A Weaker global growth outlook, and slowdowns in China and the Eurozone,
  • Tightening financial conditions due to stock market falls and the strong dollar, and
  • The effects of the U.S. government shutdown.

However, the Fed’s mandate is to maintain full employment consistent with a stable inflation rate near 2 percent. U.S. inflation is currently below the Fed’s 2 percent target despite unemployment being at historic lows.6 The Fed downgraded the U.S. growth outlook in December,7 which may be one reason why it has now decided to halt interest rate rises. Another reason might be to support U.S. trade by countering upwards pressure on the dollar’s exchange rate due to the weakening Chinese and Eurozone economies and the uncertainty caused by Brexit.8

 

Some analysts have also speculated that the Fed’s intention was to prevent a sustained drop in the U.S. stock market, perhaps because falling stock markets have been followed by recessions in the past.9 Others, however, wonder if the Fed’s decision signals that the U.S. economy is not quite as robust as it appears.10 If so, then U.S. businesses may face economic headwinds during 2019.

 

The

Takeaway:

The Fed’s decision to halt interest rate rises could mean a weaker dollar exchange rate going forward, which would improve terms of trade for U.S. exporters and might also mean a brighter outlook for global trade and growth. However, if the reason for the Fed’s decision is that the U.S. economy is less robust than previously thought, U.S. businesses may find trading becomes more difficult despite a weaker dollar exchange rate.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Open Market Operations,” Federal Reserve Board; https://www.federalreserve.gov/monetarypolicy/openmarket.htm
2. “Fed raises interest rates, signals more hikes ahead,” Reuters; https://www.reuters.com/article/us-usa-fed/fed-raises-interest-rates-signals-more-hikes-ahead-idUSKBN1OI0DV
3. “Federal Reserve issues FOMC statement, January 2019” Federal Reserve; https://www.federalreserve.gov/newsevents/pressreleases/monetary20190130a.htm
4. “Recession fears grow as eurozone factories stumble and China exports fall,” The Guardian; https://www.theguardian.com/business/live/2019/jan/14/china-trade-slowdown-exports-us-surplus-eurozone-industrial-production-business-live
5. “World Economic Outlook Update, January 2019,” International Monetary Fund https://www.imf.org/en/Publications/WEO/Issues/2019/01/11/weo-update-january-2019
6. “Federal Reserve issues FOMC statement, January 2019,” Federal Reserve; https://www.federalreserve.gov/newsevents/pressreleases/monetary20190130a.htm
7. “Fed cuts outlook for US economic growth in 2019,” Financial Times; https://www.ft.com/content/225bf402-03b1-11e9-9d01-cd4d49afbbe3
8. “This Is What It Sounds Like When Fed Doves Cry,” Bloomberg; https://www.bloomberg.com/opinion/articles/2019-01-31/this-is-what-it-sounds-like-when-fed-doves-cry-jrk5jzig
9. “What Is The Real Reason For The Fed’s Sudden Decision To Stop Raising Interest Rates?” Forbes; https://www.forbes.com/sites/francescoppola/2019/01/31/what-is-the-real-reason-for-the-feds-sudden-decision-to-stop-raising-interest-rates/#67fa8ca747ba
10. “The Fed’s Mysterious Pause,” Wall Street Journal; https://www.wsj.com/articles/the-feds-mysterious-pause-11548893175?mod=e2twcb

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