Guest Article Written By: Robert Blake
When the US Federal Reserve raises interest rates it always affects the US dollar. In this case, the hike would normally reduce the inflationary pressure, and as a result appreciates the dollar. The latest decision to raise the target for the fed-funds rate to a range between 1.75%-2%, in June of this year, was due to a stronger economy and a healthy US jobs market.
We mentioned previously on Crush the Market how interest rates have been steadily rising since 2015.
With three to four increases forecasted for 2018, the graph of the Fed “dot plot” below illustrates how eight policy makers expect four or more quarter-point increases for the year.
Traditionally, interest rates in the United States averaged about 5.72% from 1971 to 2018, with Money Cafe reporting a high of 20% in March 1980 and a record low of 0.25% in December 2008.
Higher interest rates generally mean a lower economic growth, but also slower inflation. In the past, the best way to achieve full employment and stable prices was to set the inflation rate of the dollar at 2%, which would grow the economy at a healthy pace. The Fed hiked this year, in response to a growing economy and fear of rising inflation, increased interest rates by a quarter of a percentage point. Jerome Powell, Chairman of the Federal Reserve, remarked that the “economy is doing very well,” following the rate hike announcement. The graph below shows the historical Fed rates over a period of 47 years.
Historically, even with low interest rates the US dollar enjoyed favorable exchanges rates in relation to major currencies like the Euro or the Pound. Investopedia reveals that this is in part due to the US dollar being the reserve currency for much of the world. As a result of higher interest rates and a strengthening dollar, more Forex traders will be hedging on the US dollar.
FXCM outlines that the Forex market trades an average volume exceeding $5 trillion daily, and the current Fed interest rate plays a factor in determining the value of the US dollar.
However, it is mainly its perception as a safe haven in uncertain economic times, which has been the main reason for its high value in relation to other currencies. However, it is mainly its perception as a safe haven in uncertain economic times, which has been the main reason for its high value in relation to other currencies.
Bloomberg reported how the dollar spot index, which tracks a number of global currencies against the US dollar, rose temporarily immediately following the Fed announcement.
As was expected, however, the trend that the Federal Open Market Committee (FOMC) is following seems to indicate that it’s stepping up the pace of rate hikes, stating that economic growth should continue regardless. While the course of the increases will remain gradual, the perceived aggressive pace demonstrates how the FOMC is looking to tighten policy amid falling unemployment levels (which fell to their lowest of 3.8% in May) and national growth.
The following chart illustrates the historical date of the price-adjusted US dollar index published by the FOMC.
U.S. Dollar Index - 43 Year Historical Chart
For now, the economic forecast indicates that core inflation will reach the Fed's target of 2% by the year’s end with an overall economic growth of 2.8% for 2018. As such, with a fourth and final hike projected for this year, the Fed indicated that it will expect more rate hikes in 2019. Despite the recent hikes, as part of their long term forecast, the committee indicated that they still see the rate increasing to 2.9% and peaking at 3.4% by 2020, with an estimated GDP increase of 2.4% in 2019 and 2% in 2020. In addition to upwards estimates for GDP and inflation, the committee also estimated a cut to their original unemployment projection, from 3.8% to 3.6% for the full year. Despite the current political turmoil in the US, the economy continues to look positive.
Author Bio: Robert Blake is a freelance financial adviser and consultant. Since gradating from university he has started writing finance articles online to help give readers a clearer understanding of the US and global economy. In his spare time he can be found visiting financial seminars.
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