When we seek to understand a concept that’s new to us, we might prompt an expert to “Explain it to me like I’m eight years old.” But last month, I learned the practical limits of that phrase. While traveling in Europe with my family, I mentioned that costs were a little cheaper for us on this trip than when we visited in 2021. My eight-year-old son asked: “Why?” Blame it on the jet lag, but I drew a blank. I said I would get back to him.
This essay is more than my penance for disappointing my kids. The post-pandemic cycle has been full of surprising movements in foreign exchange rates, and much news coverage is being presented in terms of what future policies could mean for the dollar. An assessment of where we have been will help us understand where we’re going.
Exchange rates are an expression of the relative value of a pair of currencies. They can be aggregated as indices; when one currency strengthens against another, the former’s movement will usually be similar across all its partners. Key drivers of those changes are:
Interest rate differentials: When higher interest rates are available on a nation’s debt instruments, that currency will attract more foreign investors, driving up its value. Monetary policy decisions are thus impactful for exchange rates.
Foreign reserves: Each nation’s central bank will hold a variety of assets, including currency issued by other nations. Reserves can be used to facilitate commerce across nations, and they can be bought or sold to influence currency values. For instance, high interest rates in the early 1980s pushed up the value of the U.S. dollar to an extent that distorted global commerce; the 1985 Plaza Accord relieved some of that pressure through an international agreement to devalue the dollar through reserve sales.
Economic and institutional strength: Any investment involves risk. Taking another nation’s currency entails an exposure to that nation’s financial system. International investors will prefer nations with transparent financial institutions, reliable regulations and general stability. This factor deters investment in some emerging markets that offer high interest rates with higher risk.
Maintaining a strong currency requires tradeoffs.
Trade terms and balances: Nations create demand for their currency by participating in global trade. In an import transaction, a nation receives goods or services by exporting its money. More openness to trade increases demand for that currency. But an over-reliance on imports carries risks: a persistent current account deficit will require the money to be made up from another source, like greater debt or higher taxes.
Inflation: Higher inflation tends to lead to currency depreciation as nations’ purchasing power erodes.
None of these forces are isolated, and they can offset each other. For instance, the U.S. has run a current account deficit for over 30 years, but the dollar has gained through intervals of outsized growth and continual demand for dollars to settle international transactions. And distortions must be considered in a relative manner: the recent cycle of inflation did not impair the U.S. dollar, as most other advanced economies suffered inflation of similar or worse magnitude.
All of the forces above have been at play throughout the pandemic cycle, helping to explain the current strength of the dollar.
- Interest rates rose across all markets as central banks fought a global burst of inflation. As the global easing cycle took shape this year, the Federal Reserve has taken a higher-for-longer stance, adding support to the dollar.
- Starting last year, the U.S. broke from a globally-synchronized closure and reopening cycle, with the nation’s economy outperforming its peers. This persistent strength has added to demand for U.S. assets.
- Trade has been a point of tension since well before the pandemic, with more restrictions continually added against doing business with China. However, this has been more noise than signal, as supply chains have been slow to realign.
The dollar’s outlook depends on other nations, who share limited growth prospects.
The special status of the dollar as the world’s reserve currency also confounds the typical rules. In times of stress, safe-haven flows toward U.S. assets increase, with runups evident at the onset of the Global Financial Crisis and pandemic shutdowns. Even stress emanating from the U.S., like last year’s debt ceiling debacle, did not harm the dollar.
All these forces have worked together to keep the dollar’s value elevated. In the year ahead, we forecast only a modest retreat. As the Federal Reserve starts its own cycle of rate cuts, the interest rate advantage offered by the U.S. will diminish. Growth prospects among major nations are not especially strong, with none poised for a breakout.
The strong currency is neither a blessing nor a curse. A high value improves a nation’s buying power, making its residents feel relatively well-positioned to spend and borrow (and travel abroad!). However, it makes the nation’s exports less competitive, harming sectors like mining and manufacturing. A weaker currency reverses these outcomes.
Policymakers and elected officials can steer their currencies through reserve purchases/releases and money printing. Questions are growing as to the impact of the next president on the dollar’s value. In upcoming essays, we will undertake detailed discussions of the economic aspects of the party platforms, including their potential dollar impacts. With both parties prioritizing trade and domestic production, the dollar’s value will gain more attention.
Going back to perusing a German menu with my children, I would explain: We borrow more money than most other countries do, and that made other countries not like our money for a long time. But now we’re growing faster than other countries, and that helps. It certainly helped us afford a trip to Europe this year.
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