Why you should care
Because there’s a lot of unwarranted noise about interest-rate hikes.
After years of hemming and hawing while the economy sputtered, the Federal Reserve at last is bringing the era of near-zero interest rates to an end. Last month, it announced a quarter-point increase in benchmark rates. It also expects three more rate hikes in 2017. The actions will make home and car loans more expensive, while putting a brake on inflation.
Economic theory suggests higher rates add up to a stronger dollar — particularly compared to emerging-market currencies. And that’s the line many are taking in response to the Fed’s hikes. Investment analyst Abnish Kumar Sudhanshu, for instance, told Indian newspaper The Economic Times that the hikes “will bring the rupee down against the dollar” and damage India’s economy. A commentary in China’s state-run Xinhua news service warned of “disorder worldwide” from rate hikes and the ensuing stronger dollar.
So should Americans start booking an overseas trip, counting on their dollars to go further? Not necessarily. Turns out there’s much unpredictability in this matter:
Exchange rates do not align with interest-rate shifts.
In the early 1980s, economists Kenneth Rogoff and Richard Meese, then both serving on the Federal Reserve Board, tested models to predict exchange-rate fluctuations and came up empty — showing that a “random walk” is as good an exchange-rate predictor as anything. In the three-plus decades since his study was published, Rogoff tells OZY, the results have held up well. Exchange-rate prediction models that use interest rates or other factors perform poorly over a two-year span, with some better longer-term success. So don’t count on making euros rain in Ibiza (or yuan in Shanghai) at better rates.
In the wake of Donald Trump’s election, the dollar soared against a basket of currencies, trading 40 percent higher than its 2011 lows. The trend makes the rest of the world uneasy, as the dollar’s critical role in global credit markets means pricier debt when the greenback rises. Its ascent is due in part to investors’ expectation that Trump will cut taxes and spend more on public works. It’s also a bet that the American economy will continue to outperform the rest of the developed world. Whether that bet pays off depends on a volatile mix of global factors and can’t be easily projected by interest rates.
“The fact is the dollar is already very high, with expectations of high growth and rising interest rates already built in,” says Rogoff, now an author and professor at Harvard University. “It is not easy to say whether it is likely to go up or down from here. Let’s not forget that the Trump factor itself brings a lot of unpredictability.”