What is the economic impact of a strong US Dollar?

The end of last week saw prospects for interest-rates come to the fore. In the background we had the hints and promises of Mario Draghi about the Euro area going further into the negative interest-rate zone. Then Thursday saw the “unreliable boyfriend” Mark Carney give us somewhere around Forward Guidance 8.0 as a Bank Rate rise in the UK receded around yet another corner. Following this on Friday came the strong non-farm payroll report in the United States which shifted upwards the market view of US interest-rates. However none of the above have actually happened yet and there was one area which has already shifted that is the world of currencies and exchange-rates.

You may choose to consider this in the light of the famous “currency wars” statement from September 2010 or not but the truth is that a long list of countries are trying to manipulate the value of their currencies right now. For all the talk of interest-rate changes and extraordinary monetary measures if we look at economies the main player these days is the exchange-rate which the media often overlooks.

The strong dollar

This is a fact of life and let me illustrate it with some detail from DailyFX on Friday and the emphasis is mine.

Eight months of congestion have been brought to a dramatic end this past week as the US Dollar mounted an impressive rally in the aftermath of the October labor report……Now that we have seen rate speculation soar and the Dollar break to 12-year highs, many will simply presume the currency to continue rising under its own.

speculative momentum.

Unfortunately the St.Louis Federal Reserve is rather tardy in updating the official measure so let as take a look at that hardy perennial the US Dollar Index. It has been in a bull market since late April 2011 when it dipped below 73 although the main move to the current level of 99 has been since the summer of 2014. Just for clarity it is not at its equivalent highs to the official measure for the simple reason that it covers the major currencies and misses out the moves against the South American currencies for example. The extreme move there has been against the Brazilian Real which has fallen by 41% in 2015 so far.

Some care is needed with the hype as I note that Goldman Sachs is projecting the US Dollar a fair bit higher as one could just as reasonably point out in terms of interest-rates buy the rumour and sell the fact. After all who wants to be a “muppet”.

The economic impact

If we were analysing the UK then the rally in the US Dollar since the summer of 2014 would be equivalent to a 4.75% rise in Bank Rate. Again care is needed because the US Dollar’s role as a reserve currency and the fact that in relative terms it is less of a trading nation means one would expect a lower impact on two counts.

The US Federal Reserve itself is noticeably reticent on the issue I was all over their speeches earlier in the year when the US Dollar but they veered away from being specific. However Vice-Chairman Fischer tell us this.

Thus, it is plausible to think that the rise in the dollar over the past year would restrain growth of real GDP through 2016 and perhaps into 2017 as well.

If we use the chart he produced and add the current numbers to it then we might reasonable expect there to be a total reduction in the path of US GDP by around 1.5% peaking late next year. The effect on core inflation is faster and would be of the order of 1% and if it is not in play now it soon will be. Here is the chart that he used.

I counsel a dash of salt with such analysis as it is a generalised expectation and in reality there are always other influences.

What about trade?

The main player in the impact on economic growth is trade and the New York Fed offered us a view back in July on the expected impact. It concentrates on the impact of exports because the impact on US imports is lower via its role as the reserve currency. For the UK or Europe a change in the currency changes the price of oil,copper,steel. many foods and so on but the US does not see that due to the vast majority being priced in the US Dollar.

The numbers here are as follows.

The New York Fed trade model suggests that a 10 percent appreciation of the U.S. dollar is associated with a 2.6 percent drop in real export values over the year. Consequently, the net export contribution to GDP growth over the year is 0.5 percentage point lower than it would have been without the appreciation and a cumulative 0.7 percentage point lower after two years

So in approximate terms we have a present impact in play of around double that.

Ceteris Paribus

The estimates above all rely on that latin phrase which means “all other things being equal”. Of course they never are! And the history of the credit crunch is that a lot is in play at whatever point you choose. Let me illustrate by picking just one influence the price of Dr.Copper.

This has been falling since early 2013 in this phase although the peak was back in 2011. Over the past year it has dropped by just over a quarter to US $2.24. Now if we look at its impact on the US economy we see that step one provides a boost via a cheaper price for a basic commodity. Monetary policy muddies the waters a little as the US Federal Reserve of course does not like something which it has contributed to which is lower inflation. But a simple step one is easy. Happy Days.

However it does not stop there as there are losers such as commodity producers as well as other winners such as other commodity consumers. Then we have something perhaps not so cheery if we consider why it is falling in price? As if that is less demand than we thought we had then Taylor Swift needs to get ready for a burst of “trouble,trouble,trouble”. On that road we can look at yet another disappointing set of trade figures from China over the weekend as it is a major commodity player/consumer.

If we look at other countries you might think that they would be unreservedly happy as they have a lower exchange rate versus the US Dollar in general. The Bank of Japan and the European Central Bank will be pleased it is helping with something they wanted anyway. But others such as many South American countries and others will be frowning as their falls have created problems with inflation. You might think that such a thing is very odd in our current disinflationary environment but I guess over time there have been examples of fires in the Arctic.

Also it would be remiss of me to remind you of the generalisation that commodity prices often move in the opposite direction to the US Dollar which creates its own cross-currents. This time around a stronger US Dollar has also seen falls in the gold price.

Comment

There is much to consider here and let me return to the subject of interest-rates. Back in September a major factor in the US Federal Reserve’s inaction was in my opinion concerns over low commodity prices and a strong dollar. Those who automatically assume it will raise next month might lie to note that they are back. The dollar rise reigns back the chances of a rate rise but of course did it depend on expectations of it? I will stop there on that point as you can just keep going and merely point out that for the US and indeed Euro area and UK in 2015 the main monetary player has been the exchange rate as yes I do count the beginnings of ECB QE in that especially after the latest disappointing business lending figures. But of course the relationship between QE and currency value is another area where one can end up “spinning around” like Kylie albeit much less gracefully.

One important factor we do not know is how long this will last as we will not know the full impact until as George Bension put it “hindsight is 20/20 vision”.

As for musical influences well the financial markets have been singing along to Aloe Blacc for a while now.

I need a dollar dollar, a dollar is what I need
hey hey
Well I need a dollar dollar, a dollar is what I need
hey hey
And I said I need dollar dollar, a dollar is what I need
And if I share with you my story would you share your dollar with me

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15 thoughts on “What is the economic impact of a strong US Dollar?

    • Hi therrawbuzzin

      What we do not know is whether the US Dollar will remain strong between now and the next Federal Reserve meeting but if it does then it will face the same set of questions as September when it did nothing. Meanwhile today the ECB was leaking yet more rumours and hints about its planned deposit rate cuts. Oh for a world not simply front-running central banks!

  1. Forward guidance is much like the story of the boy who cried wolf.Each time they talk,the less impact it has.

    The Fed is in a different position due to the Dollar’s reserve status.At some point they will raise and then potentially,all hell will break loose in the EM sphere.So much dollar denominated debt and worthless specie or crumbling commodity prices to fund it with.Which is why I think the Fed will hold off in December.I can’t foresee a scenario where Yellen will be able to balance the fear of inflation(because that’s pretty much all they’re going to base that decision on) with the risks to the global debt bubble.

    The unreliable boyfriend-as ever-will await the result of the test before he makes a decision on whether to run,dig a deep hole or buy precious metals.

    • Hi Dutch

      Usually the US Federal Reserve sets interest-rate policy for itself and for the US that kind of works because relatively it is not a large trading nation. Of course though it has lots of impacts around the world and we do know that the Fed mulled the Emerging Markets crisis it helped trigger and also worries about China. I think that they are actually silly enough to believe that if they keep crying wolf markets will continue to believe them

  2. You have to wonder what these central bankers actually discuss at Davos and Jacksonhole etc? I would have thought coordinated interest rate increases to cancel out exchange rate fluctuations would have been top of the agenda. This present situation is ludicrous and for so much hullabaloo to be generated about what is probably only a 0.25% increase is an indicator of the madness that exists in financial markets. The problem is that in the absence of any other defining data the gamblers in stocks and shares and currencies look for the tiniest indicator of how things will move in the short term. Step forward men of vision and conviction. If there are any?

    • Hi Pavlaki

      The problem with interest-rates again takes us back to the Euro as Reuters reported this today.

      “A consensus is forming at the European Central Bank to take the interest rate it charges banks to park money deeper into negative territory in December, four governing council members said, a move that could weaken the euro and push up inflation.

      Some argue that a deposit rate cut should even be larger than the 0.1 percent reduction currently expected in financial markets, the policymakers said.”

      Now that may be pure speculation but the Draghi speeches headed in that direction too. Also as the ECB meets on the 3rd of December it has the chance to strike first and present itself as a type of Xmas present, and leave Yellen to play Scrooge if she wishes….

  3. Hi Shaun

    I think your question is somewhat more tantalizing than it appears.

    Ceteris paribus you would think that commodity prices would increase with an increase in the $US. However, that is perhaps with the implicit assumption that a rate increase either presages higher inflation, in which case there would be a move into commodities as an inflation hedge; or an uptick in economic growth which means greater demand. In this case it would appear that a strengthening $US could mean lower exports but also higher imported commodity costs which would feed through into inflation, which is what the Fed appears to want.

    However, as we don’t appear to have either incipient inflation or resurgent economic growth then it is arguable that this scenario will not play out as described. Let’s face it there’s a reason for the Fed to loosen, not tighten at the moment.

    Interestingly as the Fed has now ended QE but the ECB and the BOJ have not the Yen and the Euro have fallen in relation to the dollar which has meant that commodity reductions in dollar terms has been felt much less in the Euro area and Japan due to the relative exchange rate effect, so any “inflation” bonus has been felt more in the Euro are and Japan than in the US.

    • seems to me that the Bankers are in a cahoots as each one in turn takes on more QE

      so as the ECB stops I expect the Fed to pickup again..

      we shall see

      Forbin

  4. Hi Shaun, on a purely selfish note (well this is a capitalist society) the economic effect of a strong dollar for me is loadsamoney as I have quite a few dollar denominated holdings – YAHOO!

    The effect for the rest of the world? Well, given most commodities are priced in US $ maybe they’ll start to see some of that elusive inflation they are chasing so earnestly, assuming no further commodity price falls. Now, all the CB’s of the world have to do, is convince the Fed to raise it’s rates…..

    • Hi Noo2

      Whilst some of the central bankers may be fans of a Federal Reserve interest-rate rises we can count out the central bankers of Africa many of whom have been finding themselves raising interest-rates on a scale which would give Yellen and Carney sleepless nights. It was only last week that the Bank of Zambia raised interest-rates by 3% to 15.5% and Ghana has a policy rate of 25%.

      So congratulations and watch the show…..

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