By Frances Coppola
The US dollar exchange rate fell 4.2% in the first quarter of 2016, after rising consistently since 2014. The NASDAQ reports that many US companies see this as good news: a weaker dollar makes exports more competitive and reduces losses due to currency conversion on the income from overseas sales. Now “all eyes are on the Federal Reserve” in the hope that it can prevent the dollar from rising again.1
Economic theory tells us that the Fed’s interest rate policy should influence the US dollar exchange rate. When interest rates rise, investors looking for return buy dollars in order to purchase dollar-denominated assets: increased demand for dollars in FX trading puts upwards pressure on the US dollar exchange rate (the “price” of the currency). Conversely, falling interest rates encourage investors to sell dollar-denominated assets, investing their money in foreign assets that give higher returns: as investors sell their dollars for other currencies, the price of the dollar versus those currencies falls.
But it’s not that simple. In FX trading, financial instruments can be used to “lock in” exchange rates: investors may hedge against the impact of interest rate changes. The effect of interest rate adjustments on US dollar exchange rates is therefore uncertain. When the Fed Funds rate was cut to 0.5% after the financial crisis of 2008, the US dollar exchange rate fell sharply: but the interest rate increase in December 2015 had little effect.
Markets respond not only to Fed announcements, but even to remarks by Fed officials. And investors have a view as to what they think the Fed should be doing. The Fed likes to signal its plans in advance – so-called “forward guidance.” This is to prevent unforeseen federal policy actions causing market panics, and to “guide” markets along the path set by the Fed. For example, the interest rate rise in December 2015, which passed with barely a ripple, was signalled months in advance. .
But forward guidance can have perverse effects. When markets disagree with central bank policy, the response can be market turmoil: foreign currency exchange rates may even move in the opposite direction from that intended.
So far, Federal Reserve chief Janet Yellen has managed to avoid signalling policy actions that markets don’t agree with. Yellen’s recent remarks about interest rates possibly remaining lower for longer were greeted with resignation rather than consternation. The US dollar exchange rate fell as expected.2
But in Europe and Japan, announcements of “inadequate” monetary stimulus caused a flurry of dollar buying, pushing up Euro3 and yen 4exchange rates and thus weakening the dollar – exactly the opposite of what those central banks hoped to achieve. The Fed could support the dollar by raising interest rates. But as a weaker dollar is helpful to the US economy, it has left well alone.
And this raises an important point.
Although the Fed’s purpose is to manage the domestic US economy, its actions have external effects. Similarly, the behaviour of other major central banks affects the US economy – as do global economic shocks such as oil price changes, and natural disasters elsewhere in the world. The Fed uses federal policies to buffer the US economy from these external effects.
But central banks do not operate alone. US federal policies influence the actions of other central banks, and the policies of other central banks influence the Fed. Sometimes, actions by other central banks can mean the Fed needs to do less to meet its mandate. At other times, they can mean it has to do more. And the final judgment of the adequacy of Fed response rests with the markets.
The attractiveness to investors of each currency is reflected in market behaviour. Federal policies influence the US dollar exchange rate, but ultimately, the price of the dollar is discovered in FX trading.
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.