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Economic Update

2018/06/13

Will Higher Interest Rates Mean a Stronger Dollar?

At its June meeting, the U.S. Federal Reserve is expected to raise interest rates by 25 basis points to a range of 1.75% to 2%, marking the seventh rate hike since December 2015. A common belief is that higher interest rates make a currency more attractive to investors, thereby pushing up the demand for the currency and thus its value.

So when the United States began its monetary policy normalisation more than two years ago, some of you might have expected the greenback to strengthen in a meaningful way. Supporting this view is the fact that other major central banks maintained their borrowing costs at ultra-low levels, making goods imported from other countries cheaper for Americans while hurting the export competitiveness of U.S. companies. 

Makes sense, right? However, in reality, the underlying mechanism is much more complicated, as the U.S. dollar's movements on a longer horizon depend on many factors in addition to short-term interest rates.

For instance, the currency value also depends on the respective economic prospects of the U.S. and the rest of the world, the current account balance and inflation outlook, among other things. Meanwhile, political developments in Washington and the recent trade spats between the U.S. and its major trading partners could also affect the attractiveness of the greenback.

As a result, the assumed strong appreciation of the dollar during the current tightening cycle has not materialised. Figure 1 shows the movement of the trade-weighted U.S. dollar index, which is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.

A higher value of the index indicates a stronger dollar. Although the index rose significantly in the run-up to the first rate hike of the current tightening cycle, it has not shown any conspicuous upward trend since then. In contrast, it fell by nearly 1% since the beginning of 2016 despite the recent surge.

A rate hike doesn’t guarantee a rise in the dollar. And if someone tells you that a currency is going to appreciate solely because of higher interest rates, think again. But one thing is certain: as the U.S. is set to lift interest rates further, commercial banks in Hong Kong are one step closer to increasing their prime rates, which have remained virtually static since 2008.

In terms of the domestic economy, higher interest rates will have negative impacts on consumption and investment. While Hong Kong’s economy registered strong growth in the first quarter, up 4.7% compared to a year earlier, we should perhaps be prepared for rainy days.

 

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