Interest Rates and the Dollar

March 18, 2008 – 6:47 pm

Why do lower interest rates depress the value of the dollar? And why should you care? Good questions worthy of a textbook-length response. I will try my best…..

First of all, it shouldn’t take much to convince you that you care about the value of the dollar. When its value declines that means, quite literally, that your dollars command less in terms of goods and services in the economy. Four years ago, one dollar purchased nearly a full gallon of regular unleaded gasoline. Today it buys only a quarter of a gallon…..

Now that you know you care about the dollar’s value, you may want to know some of the determining factors. One factor is interest rates. And the simple answer to the first question above–why lower interest rates depress the dollar’s value–is that lower interest rates for a currency reduce the incentive to save that currency.

Domestically-speaking, this rule means people have less incentive to park their money in a bank and more incentive to spend it. More spending means more dollars are floating around the economy. More dollars chasing a fixed number of goods will drive up the price of those goods (think Manhattan real estate: with so much Wall Street wealth floating around this island and only a fixed amount of land on it, real estate costs more here per square foot than anywhere else in the U.S.).

Internationally-speaking, the rule means investors have an incentive to move their money to countries where their savings will pay a higher rate of interest. So for instance, after today’s Fed rate cut, short-term U.S. savings will get an annualized rate of return between 2 and 3%. That’s down from over 5% less than 6 months ago. Compare that with the 4% rate of interest savers get in Europe right now. 4% interest vs. 2% interest. All else equal, investors with the option to save in dollars or in euros prefer to save in euros.

But how do those currently invested in dollars switch their savings to euros? How would you open a euro savings account if you only have dollars in your pocket? You simply exchange your dollars for euros, which you then put in a euro savings account. “Exchanging” dollars for euros is the same as “selling” your dollars for euros.

Remember that: SELLING dollars, BUYING euros. That’s the transaction that happens on foreign exchange markets when investors want to switch from “dollar-denominated” assets to “euro-denominated” assets.

Forgive me for repeating myself, but just so we’re clear:

If interest rates on dollar savings are going down, which they are, while interest rates on euro savings are staying the same, which they are, then it stands to reason that investors who have their savings in dollars would want to exchange them for savings in euros. To do that they have to sell dollars and buy euros. The demand for dollars is going down; the demand for euros is going up.

Here one need only recall the fundamental law of supply and demand: all else being equal, if demand for a commodity falls then so does the commodity’s price. The dollar is a commodity like any other and is subject to the same laws of supply and demand.

If investors increasingly demand euros instead of dollars for their savings accounts, then the value of the dollar will fall relative to the value of the euro. The chart below tracks the price of the dollar as quoted in euros since December 2005:

In December of 2005, one U.S. dollar purchased 0.86 euros, now it purchases 0.63 euros. The dollar buys 27% fewer euros today than it did just over two years ago.

Let’s add a complicating factor here: the trade deficit. What does the trade deficit have to do with the falling value of the dollar? Plenty. The most salient fact is that it turns America’s largest trading partners into some of the largest savers of dollars. Savers who have a larger incentive to shift their savings into higher-yielding euros each time the Fed cuts rates.

THE TRADE DEFICIT

Consider that every time an American imports a commodity from abroad he trades his dollars for it. For example, an American might trade $1 in exchange for a toy made in China. Or he could trade $109 for a barrel of oil dug from the ground in the Middle East. They get our dollars, we get their goods.

To help you, the individual consumer, appreciate exactly how YOU contribute to the trade deficit, it’s important to understand the middlemen who keep the process going. These middlemen buy goods from overseas, bring them back to the U.S. and then sell them to you. Walmart is a good example. To keep its prices so low, it searches out the lowest cost producers for all the stuff it stocks on its shelves, many of whom are located abroad. When you buy a toy at Walmart with a “made in China” label, the behemoth retailer is facilitating trade between you and a Chinese producer.

Again: you give the Chinese a dollar and get a toy in return.

Trade tends to be a two-way street. Most economies that sell goods to America also buy goods from America. And the mechanics are the same, just reversed. They give us currency, we give them American-made goods.

America has a trade “deficit” because we buy more foreign goods than foreigners buy American goods. $60 billion more per month to be exact. $2 billion more per day. That’s the net amount of cash we send abroad in exchange for goods and services. (Swedish massage anyone?)

Many foreign economies rely on trade with the U.S. in order to drive growth. It’s in their interest to keep the prices of their goods competitive in dollar terms so that American consumers keep buying them. To do so, foreign governments have to prevent their currencies from rising in value versus the dollar, which can be tough because the constant flow of dollars into their economies makes those dollars worth less.

To prevent their currencies from rising in value against the dollar, foreign central banks must mop up the flood of dollars flowing into their economies by purchasing them with their own currency.

In this and other ways, $2 billion a day finds its way into the savings accounts of foreigners and foreign governments.

And now we’re back to where we started: savings denominated in dollars….trillions of them in the vaults of foreign governments, which they turn around and invest in U.S. treasuries and mortgage-backed securities.

As the Fed cuts rates, it gives foreign governments an incentive to shift their savings into higher-yielding currencies.

Remember the basic relationship we specified above? As savers shift their savings into currencies other than the dollar, the value of the dollar falls relative to the currency into which they’ve converted their savings. This was because to effect the trade, the saver has to SELL dollars and BUY the other currency. Lower demand for dollars…..law of supply and demand….the dollar’s value falls. You’ve got it now.

But foreign countries that rely on trade with the U.S. to drive economic growth are loath to let the dollar fall since it would make their exports more expensive/less appealing to American consumers.

But at a certain point, some experts worry that the constant flood of dollars into their economies–combined with more Fed rate cuts that make those dollars less valuable savings vehicles–could cause certain foreign governments so much inflation at home that they have no choice but to let their currencies rise:

The inflation mechanics are as follows. The pegging central bank has to buy U.S. dollars in the foreign exchange market in order to prevent the dollar from falling against its currency. The dollar-buying central bank purchases dollars with its own currency. The dollar-buying central bank gets its own currency the same way all central banks get their own currency – it figuratively “prints” it. The dollar-purchasing central bank therefore floods its economy with its own base money, resulting in inflation – inflation in the prices of goods/services and inflation in the prices of assets. [The above is often referred to in shorthand as the U.S. "exporting inflation."]

…in our opinion, what could turn a walk on the dollar into a sprint would be a decision by the Chinese and/or Saudi central banks to eliminate the pegs of their currencies to the greenback. Now, what would motivate these central banks to sever the peg? The desire to rein in their domestic inflation. In an environment in which the dollar is under downward pressure, the by-product of pegging one’s currency is higher inflation in the economy whose central bank is pegging.

It’s not exactly easy for a government with trillions of dollars in its bank to convert them quickly into other currency. So a “sprint” from the dollar by governments that hold them isn’t a high probability event. And yet it seems unwise for the Fed to tempt fate……

As we noted at the top, you care about a fall in the value of the dollar because that means you can’t buy as much stuff. A dollar is, after all, only worth what it will buy……

[Why in God's name would the Fed cut interest rates if it could cause a dollar stampede? Good question......but I'm tired so will save that one for another day.....]

………………
Read other posts on OptionARMageddon:

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Capital Raising, Merrill trickery
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Sanity at last? Paulson rejects bailouts
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Baltimore Sun Op-Ed: Ron Paul calls it on Fannie and Freddie

  1. 6 Responses to “Interest Rates and the Dollar”

  2. Because they are intentionally destroying the dollar. The dollar is one of the last things standing in the way of a North American Union (EU style) with a new currency, no trade boundaries, and unfortunately essentially no borders.

    It sounds like a conspiracy theory, but unfortunately its the only thing that explains the entire actions of the government, on every front. Economy, check. Border, check. Giving billions to Mexico, check.

    By Brian on Mar 19, 2008

  3. Oh RW you are my little econ prince. This actually will solve an argument I was having with the bf the other day, but I couldn’t explain it properly (without using the words “thingy” and “the other thingy”). He was also wouldn’t accept that “I’m smarter than you, just accept that I’m right,” was a valid and logical argument

    By Rachel on Mar 19, 2008

  4. Why do you think China will use inflated US dollars to buy US bond?

    They should and they will buy gold from US. Which is the reason why gold price popped up so fast?

    By michael lee on Mar 19, 2008

  5. Actually, if you look at Yuan exchange rates, they’ve already “depegged”. We’ve started to loose value to the Yuan just in the last year, pointing to a non-vocal move by them into the euro. They did exactly as our Congress yelled at them to do, stop pegging the Yuan to the dollar.

    By LtRand on Mar 19, 2008

  6. Normally as a currency falls imports become expensive and exports become cheap to others, hence leading to improvements in the balance of payments.

    Unfortunately in the case of the USA made in the “US of A” is not a thing globally associated with anything except Jets and weapons. So what would we sell to the world? movies? songs? I think most countries have their own. I do not think a cheaper Harry Potter will occur anyway.

    By JackoByte on Jul 4, 2008

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