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The U.S. Federal Reserve may start cutting rates of interest before yr’s end. That would make future trips abroad costlier for the nation’s travelers.
That is resulting from how interest-rate policy affects the strength of the U.S. dollar.
Here’s the essential idea: An environment of rising U.S. rates of interest relative to those in other nations is mostly “dollar positive,” said Jonathan Petersen, senior markets economist and foreign exchange specialist at Capital Economics.
In other words, rising rates underpin a stronger U.S. dollar versus foreign currency echange. Americans can purchase more stuff with their money overseas.
The alternative dynamic — falling rates of interest — tends to be “dollar negative,” Petersen said. A weaker dollar means Americans can purchase less abroad.
Fed officials in June signaled they expect to chop rates once in 2024 and 4 additional times in 2025.
“Our expectation for now’s the dollar will come under more pressure next yr,” Petersen said.
Nevertheless, that is not necessarily a foregone conclusion. Some financial experts think the dollar’s strength can have endurance.
“There have been quite a couple of headlines calling for the U.S. dollar’s demise,” Richard Madigan, chief investment officer at J.P. Morgan Private Bank, wrote in a recent note. “I proceed to imagine the dollar stays the one-eyed man within the land of the blind.”
Why the U.S. dollar gives a ‘discount’ overseas
The Fed began raising rates of interest aggressively in March 2022 to tame high pandemic-era inflation. By July 2023, the central bank had raised rates to their highest level in 23 years.
The dollar’s strength surged against that backdrop.
The Nominal Broad U.S. Dollar Index is higher than at any pre-pandemic point dating to not less than 2006, when the central bank began tracking such data. The index gauges the dollar’s appreciation relative to currencies of the nation’s foremost trading partners similar to the euro, the Canadian dollar and the Japanese yen.
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For instance, in July 2022, the U.S. dollar reached parity with the euro for the primary time in 20 years, meaning that they had a 1:1 exchange rate. (The euro has since rebounded a bit.)
In early July, the U.S. dollar hit its strongest level against the yen in 38 years.
A powerful U.S. dollar gives “a reduction on every part you are purchasing when you’re abroad,” Petersen said.
“In a way, it’s never been cheaper to go to Japan,” he added.
A record variety of Americans visited Japan in April, in accordance with the Asian nation’s tourism board. Benjamin Atwater, a communications specialist at InsideAsia Tours, a travel agency, attributes that partly to the financial incentive bestowed by a robust dollar.
In actual fact, he personally recently prolonged a piece trip to Japan by every week and a half — as a substitute of opting to travel elsewhere in Asia — largely due to favorable exchange rate.
Every thing from meals, hotels, souvenirs and the rental automobile were a “great value,” said Atwater, who lives in Denver and has long desired to travel to Japan.
“It was at all times portrayed as some of the expensive places you may go, [but] I used to be getting a few of best steaks I’ve ever had for like $12,” he said.
How rates of interest impact the U.S. dollar
In point of fact, the dynamics driving dollar fluctuations are more complex than whether the Fed raises or lowers rates of interest.
The differential in U.S. rates versus other nations is what’s significant, economists said. Fed policy doesn’t exist in a vacuum: Other central banks are also concurrently making interest-rate selections.
The European Central Bank cut rates of interest in June, for instance. Meanwhile, the Fed has kept rates higher for longer than many forecasters anticipated — meaning the speed differential between the U.S. and Europe has widened, helping support the dollar.
“The Fed’s on hold, other central banks are on the point of ease and the Bank of Japan (BoJ) seems stuck in a moment,” J.P. Morgan’s Madigan wrote.
U.S. Federal Reserve Chair Jerome Powell speaks during a Senate Banking, Housing, and Urban Affairs Committee hearing on July 9, 2024.
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“If Japan wants the yen to stabilize, policy rates have to move higher,” he added. “That does not look like happening anytime soon. With the ECB expected to chop ahead of the Fed, I expect current euro weakness to also prevail.”
This is occurring against the backdrop of a comparatively strong U.S. economy, which also generally supports a robust dollar, Petersen said. At a high level, a robust economy means there’ll generally be higher economic growth and/or inflation, which implies a greater likelihood the Fed will keep rates of interest relatively high, he said.
A powerful economy also typically incentivizes foreigners to park extra money within the U.S., he said.
For instance, investors generally get a greater return on money when rates of interest are high. If an investor in Europe or Asia were getting perhaps 1% or 2% on checking account holdings while such holdings within the U.S. were yielding 5%, that investor might shift some money to the U.S., Petersen said.
Or, an investor might want more to carry more of their portfolio in U.S. reasonably than European stocks if the economic growth outlook wasn’t good in Europe, he said.
In such cases, foreigners buy dollar-denominated financial assets. They’d sell their local currency and buy the dollar, a process that ultimately bids up the dollar’s strength, Petersen said.
Exchange rates “all come right down to capital flows,” he said.
While these dynamics also hold true in emerging markets, currency fluctuations could be more volatile than in developed nations resulting from aspects like political shocks and risks to commodity prices like those of oil, he added.
