The Federal Reserve is raising interest rates faster and greater than most other countries. Some Wall Streeters and others who built strategies around 0% interest rates have complained and offered dire consequences – primarily that a recession is coming as a result.
However, the Fed’s actions are successfully producing a dramatically positive advancement. First, by rebuilding the previously lost interest income flow on the $trillions of short-term savings and investments. Second, by advancing the U.S. financial system to the forefront as other low-interest-rate countries (trading partners) drag their heels (Europe), remain committed to the 0% beliefs (Japan), or struggle with economy weakness (China). Then there are the others who are mirroring the Fed’s actions to stay abreast of the developing improvements (Canada).
Importantly, the Fed is conducting this rate-rising process with full transparency. The systematic step-by-step increases are supported by sound rationale and forward-looking statements. By building future expectations into the markets, each official announcement is a non-event confirmation. This graph shows this shock-proof approach at work.
The measure of success: A strong currency
Some say a weak dollar is better because U.S. exports are competitively cheaper in other countries’ currencies. The quick retort is that the U.S. imports more than it exports, and the strong dollar has made most of those imports cheaper. Moreover, there is more good in a strong currency than import/export pricing.
History shows that a stronger currency is tied to superior overall economy and financial performance and, importantly, freedom of action. A weaker currency puts a country and its citizens at a disadvantage (the reason Japan is now buying Yen to reverse its declining exchange rate).
Note: The link between interest rates and exchange rates is straightforward. As the U.S. interest rates rise relative to Europe’s and Japan’s, investors have been enticed to move out of the Euro and Yen into the U.S. Dollar to purchase U.S. investments. That increased demand pushes up the dollar’s exchange rate. An example of a reverse case today is Turkey. From The Wall Street Journal (Oct. 21): “Turkish Central Bank Cuts Key Rate Again – Government doubles down on economic policy that has caused a currency collapse.”
The proof of the Fed’s success so far
The table below shows four major trading partners with whom the U.S. has a trading deficit (that is, U.S. imports exceed exports). Each country has a different strategy for handling their interest rates.
The graph below shows the result of those interest rate policies in terms of changed exchange rates. Overall, the dollar has increased significantly this year due to its higher/faster interest rate policy.
The benefits of the exchange rate improvements are:
- Capital is flowing into the U.S. (the demand side of a stronger currency)
- Imports priced in weaker currencies now are cheaper in the U.S.
- Imports priced globally in dollars (e.g., oil and gold) now are relatively cheaper in the U.S.
- Then, the biggie – the playing field has tilted in favor of the U.S. This is where “freedom of action” comes in. It means that foreign properties, businesses, goods, services are lower priced in dollar terms. (This is the time people say, “Now is a great time to travel to….”)
(Also note that those lower relative U.S. prices also mean lower relative U.S. inflation.)
The bottom line: A strong currency begets a strong currency
Once a country’s currency is seen as being strong, it tends to retain that perception and position. The Federal Reserve’s actions, transparency and commitment to control inflation are adding to the U.S. dollar’s desirability. Moreover, the strengthening U.S. dollar is also bolstering its position as a premier reserve currency.