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Exchange Rates and the Booming U.S. Economy

By Frances Coppola

The U.S. economy is booming. The February 2018 "nowcast" from the Federal Reserve Bank of Atlanta shows that GDP growth could reach 5.4 percent in the first quarter of 2018.1 It also forecasts consumer spending rising by 4 percent, and fixed investment rising by 9.2 percent due to strong growth in the construction sector.

The forecast from the Federal Open Market Committee (FOMC) is more cautious, anticipating annual GDP growth for 2018 of 2.5 percent, but also shows "core" (PCE) inflation rising to 1.9 percent.2 Meanwhile, figures from the Bureau of Labor Statistics show that unemployment remains low at 4.1 percent,3 and wages rose 2.6 percent in 2017.4

 

Businesses engaged in international trade may wish to consider what all of this might mean for exchange rates.

 

Higher Interest Rates Usually Mean Stronger Exchange Rates

 

A fast rate of GDP growth coupled with rising wages can mean higher inflation, especially if the growth rate is driven by rising consumer spending. When consumer demand is strong, companies may raise prices in response to higher labor costs. When this happens across a wide range of goods and services, PCE inflation can rise.

 

The Federal Reserve (Fed) aims to maintain PCE inflation at about 2 percent per annum over the medium term.5 Currently, PCE inflation is below target, reflecting weak wage growth and consumer spending since the 2008 financial crisis. The FOMC's forecast shows inflation gradually rising to reach 2 percent in 2019. But if the booming U.S. economy resulted in PCE inflation rising more than currently forecast, then the Fed could respond by raising interest rates faster than expected.

 

Currently, the Fed is signaling three interest rate increases in 2018. But many analysts now expect there to be four or more rises.6 Since higher interest rates encourage investors to buy dollar-denominated assets, raising demand for the U.S. dollar, a faster pace of interest rate increases could mean the U.S. dollar exchange rate may rise against all currencies.

 

But What Will Other Central Banks Do?

 

However, the path of the U.S. dollar exchange rate also is subject to monetary policy decisions by other central banks. For example, if the Bank of Japan also embarked on a program of interest rate rises, as some predict, the U.S. dollar's exchange rate versus the yen might not rise. If several major banks simultaneously tightened policy, then the U.S. dollar's trade-weighted index could remain stable.

 

How likely is it that other central banks will also tighten policy? That depends on the outlook for their economies.

 

The International Monetary Fund's (IMF's) most recent World Economic Outlook anticipates 2018 will be a good year for the global economy. It forecasts global GDP growth of 3.9 percent by 2019, up 0.2 percent from 2017. It says that about half of this is driven by tax reform in the U.S. generating spillover stimulus for its major trading partners. This not only reflects the importance of the U.S. to the global economy, it also suggests that the economies of major U.S. trading partners could benefit from the U.S.'s economic boom. The IMF particularly highlights Canada and Mexico as potential beneficiaries from the U.S. reforms.7

 

The IMF predicts that most major economies will experience GDP growth of between 2 and 3 percent, including the Eurozone, which is recovering from its recent depression. Exceptions include the U.K., where economic uncertainty weighs on growth, and Japan, still struggling to end years of stagnation.8

 

However, it is not GDP growth that determines central bank interest rate policy, but inflation expectations. Inflation is below target in most developed countries, and the IMF predicts only a very gradual rise in inflation to 2.1 percent on average by 2019.9 This assumes modest rises in interest rates in line with the signals currently given by central banks, including the European Central Bank's "lower for longer" approach and the Bank of Japan's resistance to market expectations of interest rate rises.10

 

The problem for central banks is that raising interest rates faster than other central banks is likely to cause their currency exchange rates to spike upwards, dampening both economic growth and inflation. They are also very anxious to avoid market disruption. So, central banks are in effect quietly coordinating policy to avoid sudden swings in exchange rates.11

 

The

Takeaway:

The U.S. economic boom may mean that the Fed raises interest rates faster than expected in 2018. This might result in a stronger exchange rate for the dollar. However, if economic conditions improve in other countries too, then their central banks may likewise raise interest rates faster than expected. Simultaneous policy tightening around the world may prevent currency exchange rates from spiking in individual countries such as the U.S. However, businesses may wish to assess the impact of anticipated higher borrowing costs in the near future.

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. “GDPNow,” Federal Reserve Bank of Atlanta; https://www.frbatlanta.org/cqer/research/gdpnow.aspx
2. “December 13, 2017: FOMC Projections Materials, accessible version,” The Federal Reserve; https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20171213.htm
3. “Employment Situation Summary,” U.S. Bureau of Labor Statistics; https://www.bls.gov/news.release/empsit.nr0.htm
4. “Employment Cost Index Summary,” U.S. Bureau of Labor Statistics; https://www.bls.gov/news.release/eci.nr0.htm
5. “The Fed – FAQs,” The Federal Reserve; https://www.federalreserve.gov/faqs/economy_14400.htm
6. “US stocks sink after jobs report,” Financial Times; https://www.ft.com/content/b236d0da-0829-11e8-9650-9c0ad2d7c5b5
7. “World Economic Outlook, January 2018,” International Monetary Fund; http://www.imf.org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-update-january-2018
8. Ibid.
9. Ibid.
10. “BoJ keeps policy steady, Kuroda dismisses talk of early exit,” Reuters; https://www.reuters.com/article/us-japan-economy-boj/boj-keeps-policy-steady-kuroda-dismisses-talk-of-early-exit-idUSKBN1EE2P5
11. “Central Banks Want The World To Carry On While They Quietly Tighten,” Bloomberg; https://www.bloomberg.com/news/articles/2017-12-14/central-banks-want-world-to-party-on-as-they-remove-punch-bowl

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