Changes in the federal funds rate could affect the US dollar. When the Federal Reserve raises the federal funds rate, it typically raises interest rates throughout the economy. The high return attracts investment capital from foreign investors looking for higher returns on bonds and interest rate products.
Global investors sell their investments denominated in their local currencies in exchange for US dollar denominated investments. The result is a strong exchange rate in favor of the US dollar.
- When the Federal Reserve raises the federal funds rate, it generally raises interest rates throughout the economy, which makes the dollar stronger.
- The high return attracts investment capital from foreign investors who seek higher returns on bonds and interest rate products.
- An increase or decrease in the fed funds rate correlates fairly well with movements in the US dollar exchange rate versus other currencies.
Understanding the Fed Funds Rate
The federal funds rate is the rate that banks charge each other for lending their excess reserves or cash. Some banks have excess cash, while other banks may require short-term liquidity. The fed funds rate is a target rate set by the Federal Reserve Bank and is usually the basis for the rate that commercial banks lend to each other.
However, the fed funds rate has a far wider impact on the economy as a whole. The fed funds rate is a key principle of interest rate markets and is used to determine the prime rate that banks charge their customers for loans. In addition, mortgage and loan rates, as well as deposit rates for savings, are affected by any change in the fed funds rate.
The Fed, through the FOMC or Federal Open Market Committee, adjusts rates based on the needs of the economy. If the FOMC believes the economy is growing too quickly, and it is likely that inflation or rising prices may occur, the FOMC will increase the fed funds rate.
Conversely, if the FOMC believes the economy is struggling or may fall into recession, the FOMC will lower the fed funds rate. High rates slow lending and the economy, while low rates spur lending and economic growth.
The Fed’s mandate is to use monetary policy to help achieve maximum employment and stable prices. During the 2008 financial crisis and the Great Recession, the Fed kept the federal funds rate at or near 0% to 0.25%. In subsequent years, the Fed raised rates as the economy improved.
Inflation, Fed Funds and the Dollar
One of the ways the Fed achieves full employment and stable prices is to set its inflation target rate at 2%. In 2011, the Fed officially adopted a 2% annual increase in the price index for personal consumption spending as its target.
In other words, as the inflation component of the index rises, it signals that the prices of goods in the economy are rising. If prices are rising but wages are not rising, the purchasing power of the people is decreasing. Inflation also affects investors. For example, if an investor holds a fixed-rate bond paying 3% and inflation rises to 2%, the investor is realistically earning only 1%.
When the economy is weak, inflation falls because there is less demand for goods to raise prices. Conversely, when the economy is strong, rising wages lead to increased spending, which can raise prices. Keeping inflation at a growth rate of 2% helps the economy to grow at a steady pace and wages increase naturally.
Adjustments to the federal funds rate can also affect inflation in the United States. When the Fed raises interest rates, it encourages people to save more and spend less, easing inflationary pressures. Conversely, when the economy is in recession or is growing very slowly, and the Fed lowers interest rates, it encourages spending that drives inflation.
How the Dollar Helps the Fed With Inflation
Of course, many factors other than the Fed influence inflation, and as a result, inflation remains below the Fed’s 2% target. The US dollar exchange rate plays a role in inflation.
For example, as US exports are sold to Europe, buyers need to convert euros to dollars in order to make a purchase. If the dollar is strengthening, the higher exchange rate will cause Europeans to pay more for American goods, based entirely on the exchange rate. As a result, US export sales could decline if the dollar is too strong.
Also, with the strengthening of the dollar, foreign imports become cheaper. If US companies are buying goods from Europe in euros and the euro is weak, or the dollar is strong, those imports are cheap. The result is cheaper products at American stores, and those lower prices translate into lower inflation.
Cheap imports help keep inflation low because American companies that produce goods domestically have to keep their prices low to compete with cheap foreign imports. A strong dollar helps make foreign imports cheaper and acts as a natural hedge to reduce the risk of inflation in the economy.
As you can imagine, the Fed closely monitors the level of dollar strength as well as inflation before making any decisions regarding the fed funds rate.
Example of Fed Funds and the US Dollar
Below we can see the fed funds rate from the mid-1990s; Gray areas indicate bearishness:
- In the mid-1990s, the fed funds rate rose from 3% to eventually exceeding 6%.
- The fed funds rate was lowered to 1% in 2001 from 6% a year earlier.
- In the mid-2000s, there was an increase in the fed funds rate as the economy improved.
- In 2008, the fed funds rate was again reduced from 5% to nearly zero and remained at zero for several years.
The federal funds rates above were obtained from FRED or the Federal Reserve Bank of St. Louis.
As the fed funds rate rises, the overall rates in the economy rise. If global capital flows into dollar-denominated assets are moving, chasing higher rates of return, the dollar strengthens.
In the chart below, we can see the movement of the US dollar over the same period as the rate hike in the previous graph.
- In the mid-1990s, when the Fed raised rates, the dollar rose as measured by the dollar index, which measures the exchange rates of a basket of currencies.
- When the Fed cut rates in 2002, the dollar weakened dramatically.
- The dollar’s relationship to fed funds broke somewhat in the mid-2000s. As the economy grew and rates rose, the dollar did not follow suit.
- The dollar only resumed to fall again in 2008 and 2009.
- As the economy emerged from the Great Recession, the dollar fluctuated for years.
- Against a backdrop of a stronger economy and eventual Fed hikes, the dollar began rising again from 2014 to 2018.
In general, and under normal economic conditions, an increase in the federal funds rate results in higher rates for interest rate products across the US, usually resulting in an increase in the US dollar.
Of course, the relationship between the fed funds rate and the dollar could be broken. In addition, there are other ways in which the dollar could weaken or strengthen. For example, demand for US bonds as a safe investment in times of turmoil may strengthen the dollar independently of where interest rates are set.