The U.S. dollar has appreciated by about 6 percent against major currencies, such as the euro and the yen, in the last two months. This comes on the heels of being beaten and pronounced undervalued by markets participants for the last six years. In fact, there are signs that the dollar’s appreciation may be sustainable and could rival its sustained strength in the early 1980s and mid-1990s.
The major tailwind that has steered the dollar upward is a favorable interest rate differential between the United States and other major countries and regions that include Japan and the eurozone.
Here in the United States, the Federal Reserve prepares to raise short-term interest rates as construction, manufacturing and automobile sales have all been strong, while the European Central Bank and the Bank of Japan are combatting deflation by pursuing more quantitative easing. The economies of the eurozone and Japan are contracting and their inflation is falling. This interest rate divergence is a power to the dollar.
The six-trillion-dollars-a-day foreign exchange market has spotted this regional interest rate divergence and the differences in economic growth rates. In fact, the dollar has spiked in one week on guesses that the Fed may change its intentions about the future plan of the U.S. interest rates, which purports that the first interest hike should come around the mid-2015.
We are approaching a major financial juncture that will resonate throughout the U.S. economy and the world, particularly if this dollar rise will prove to be sustainable (increasing for example by 20 percent). The rise in the dollar would negatively affect the foreign earnings of multinational corporations as their goods become pricier overseas. Companies that make heavy machinery such as Caterpillar and John Deere are among the most vulnerable.
The strong dollar should lower the prices of commodity that are priced in dollars. As the dollar appreciates, commodities become more expensive for buyers overseas, who have to convert their weaker currencies into the strong dollars. This should negatively affect commodity-producing countries including some of the BRIC countries — Brazil, Russia, India and China — which have been the engine of growth in the world economy. It should also weaken those countries’ currencies and their participation in the world markets.
The increases in the U.S. interest rates should also have vast impacts on the U.S. markets. They would probably upset the stock market which has already shown signs of fatigue. They should also affect the bond market, borrowing and investment. The consequential increases in mortgage rates might hurt the struggling housing sector.
Should the Fed rush and hasten the increases in interest rates? No one has an accurate answer for this question. But two factors should weight on the timing of the interest rate hikes by the Fed.
The first is that while the unemployment rate has dropped significantly in the last year or so, there is still a large pool of unemployed Americans and the labor participation rate has continued to decline.
I can also add that the August payroll report was much weaker than expected, suggesting that the economy may not be as healthy as market participants and researchers have characterized it.
The second is that wages are still low and there are no signs that they will start moving up any time soon. The mere rise in dollar should also help keep imported prices lower. Since those two factors are not changing, there is no need for the Fed to rush to increase interest rates and move the dollar up.
The Fed can afford to wait and observe the payroll numbers until at least the end of the year. Any increases in inflation can be controlled and the size of the Fed’s error should be small in the current economic and financial environment.
Shawkat Hammoudeh is a professor of economics at Drexel University He can be contacted at [email protected]