The Blessing and Burden of A Strong Dollar
Normally, strength is good. When it comes to currencies though, an abundance of strength can be too much of a good thing.
The U.S. dollar has risen sharply in recent months. That may sound positive, and in some ways it is. However, there are also some complications, and this may be a contributing factor in the severe volatility the stock market has been experiencing lately.
Here is a look at the implications of the rising dollar — first the good side of it, and then the bad.
The positive of a strong dollar
A strong dollar benefits the U.S. in many ways, including:
- Low inflation. When the dollar is strong, it makes foreign goods less expensive, resulting in lower inflation in the U.S. This effect is magnified because commodities are traded in dollar terms, so a strong dollar can make everything from wheat to oil cheaper.
- The ability to fund debt. Faith in the dollar means that there has been a steady worldwide demand for dollar-denominated securities such as Treasury bonds. That is fortunate, since the U.S. needs to keep issuing those securities to fund its massive national debt.
- Low interest rates. A strong dollar allows interest rates to remain low. For example, the U.S. has recently seen some of the lowest mortgage rates in history, which has helped revive the housing market. On an even broader scale, this makes the national debt more affordable.
- Stability. The euro crisis demonstrated how economically and politically destabilizing it is when people lose faith in a currency. Despite periodic grumbling about the level of U.S. debt, the world has yet to turn its back on the dollar to a damaging degree.
The negatives of a strong dollar
The double-edged nature of a strong currency can be seen in how some of its benefits can also be viewed as negatives:
- Low interest rates. Borrowers might rejoice in low mortgage rates, but low savings account rates have led to a devastating loss of income production for depositors.
- Debt enabling. Investors’ continued purchases of Treasury securities can be seen as enabling the nation’s debt addiction. That could eventually allow the problem to grow to an unmanageable level.
- A headwind for exports. If foreign goods are cheap because of the strong dollar, it means U.S. goods are expensive, which hurts exporters.
- Weak global growth. People are seeking refuge in the dollar because global economic growth is slowing, which is bad news for everyone.
China surpassing the U.S. as the world’s largest economy (when cost of living is factored in) received widespread news coverage recently. Actually though, given the size of the Chinese population, it is not all that remarkable. Other economies might catch up with the U.S., and there has been periodic talk about countries moving away from the U.S. dollar as their reserve currency of choice. For now though, the dollar remains the safe haven that global investors turn to in times of doubt.
This reliance on the dollar is both a blessing and a burden. As global growth slows, it is apparent once again that other nations are counting on U.S. demand to pull the economy through a weak patch. Someday, another economy might be powerful enough to carry the U.S. rather than vice versa, but that day has not yet arrived.
Frequently Asked Questions
Q: What factors determine the strength of a currency?
A: Currency trading is complicated by the fact that there are so many factors involved. Not only are there a number of country-specific variables that go into determining a currency’s strength, but there are also other benchmarks–other currencies, for example, as well as commodities–against which a currency’s strength can be measured.
However, three crucial factors are as follows:
- Interest rates. High interest rates help promote a strong currency, because foreign investors can get a higher return by investing in that country. However, the level of interest rates is relative. You’ve probably noticed that interest rates on CDs, savings accounts and money market accounts are very low right now. So are U.S. Treasury bond rates and the U.S. federal funds rate. Ordinarily, this would weaken the U.S. dollar, except for the fact that interest rates behind other major world currencies are also low.
- Economic policies. Tight fiscal discipline and anti-inflationary monetary policies help promote a strong currency. Again, this is all relative–the U.S.has its fiscal problems, but so do many other nations around the world.
- Stability. A strong government with a well-established rule of law and a history of constructive economic policies are the type of things that attract investment and thus promote a strong currency. In the case of the U.S. dollar, its strength is further augmented by the fact that commodities are generally traded in dollars, and many countries use the dollar as a reserve currency.
Speaking of stability, that is probably what governments seek for their currencies, more so than strength. A strong currency makes a country’s exports more expensive, hurting that nation’s trade competitiveness. On the other hand, a weak currency makes imports more expensive, boosting domestic inflation. So the ideal course is to aim down the middle and avoid destabilizing fluctuations.