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The Federal Reserve may begin cutting interest rates before the end of the year. This could make future trips abroad more expensive for tourists from the country.
This is due to how interest rate policy affects the strength of the U.S. dollar.
The basic idea is this: An environment in which U.S. interest rates rise relative to those in other countries is generally “good for the dollar,” said Jonathan Peterson, senior market economist and foreign exchange expert at Capital Economics.
In other words, rising interest rates support a stronger dollar against foreign currencies. Americans can buy more things with overseas money.
The opposite dynamic – falling interest rates – tends to be “negative for the dollar,” Peterson said. A weaker dollar means Americans have less purchasing power abroad.
Fed officials said in June they expected one rate cut in 2024 and four more rate cuts in 2025.
“Our current expectation is that the dollar will come under more pressure next year,” Peterson said.
However, this is not necessarily a foregone conclusion. Some financial experts believe the dollar’s strength could have staying power.
“There are quite a few headlines calling for the death of the dollar,” said Richard Madigan, chief investment officer at JPMorgan Private Bank. wrote In a recent note. “I still believe that the dollar remains a one-eyed man in a land of the blind.”
Why is the U.S. dollar “discounted” overseas?
Fed Interest rates will be raised sharply starting in March 2022 to curb high inflation during the epidemic. By July 2023, the central bank has raised interest rates to highest level In 23 years.
Against this backdrop, the U.S. dollar strengthened.
this Nominal Broad Dollar Index That’s higher than any pre-pandemic level since at least 2006, when the central bank started tracking such data. The index measures the dollar’s appreciation against the currencies of major trading partners such as the euro, Canadian dollar and Japanese yen.
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For example, in July 2022, the U.S. dollar and the euro reached parity for the first time in 20 years, meaning that their exchange rate was 1:1. (The euro has since rebounded slightly.)
In early July, the U.S. dollar exchange rate hit a record high Strongest level exchange rate against the yen over the past 38 years.
A strong dollar gives “a discount on everything you buy abroad,” Peterson said.
“In a sense, it has never been cheaper to go to Japan,” he added.
U.S. numbers hit record high Visited Japan April, according to the Asia National Tourism Administration. Benjamin Atwater, communications specialist at travel agency InsideAsia Tours, attributes this partly to the economic incentives of a strong dollar.
In fact, he personally recently extended a work trip to Japan by a week and a half instead of traveling elsewhere in Asia, largely because of the favorable exchange rate.
Atwater, who lives in Denver and has always wanted to travel to Japan, said everything from restaurants, hotels, souvenirs to rental cars was “a great value.”
“It’s always described as one of the most expensive places you can go, (but) for $12 I could get some of the best steaks I’ve ever had,” he said.
How interest rates affect the dollar
In fact, the dynamics driving dollar fluctuations are more complex than whether the Federal Reserve will raise or lower interest rates.
Economists say the difference between U.S. interest rates and those in other countries is significant. Fed policy does not exist in a vacuum: other central banks are making rate choices at the same time.
“The Fed is on hold, other central banks are preparing to ease monetary policy, and the Bank of Japan (BoJ) appears to be in trouble,” JPMorgan’s Madigan wrote.
Federal Reserve Chairman Powell delivered a speech at the Senate Banking, Housing and Urban Affairs Committee hearing on July 9, 2024.
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“If Japan wants the yen to be stable, policy rates need to go higher,” he added. “That doesn’t appear to be happening anytime soon. With the ECB expected to cut rates before the Fed, I expect current euro weakness to prevail as well.”
Peterson said this is happening against the backdrop of a relatively strong U.S. economy, which also generally supports a strong dollar. He said that at a high level, a strong economy usually means higher economic growth and/or inflation, which means the Fed is more likely to keep interest rates at relatively high levels.
A strong economy also generally provides an incentive for foreigners to keep more of their money in the United States, he said.
For example, when interest rates are high, investors typically receive better returns on their cash. If an investor in Europe or Asia earns 1% or 2% on a stock held in a bank account, and a bank account in the U.S. earns 5%, that investor may put some of that money back, Peterson said. Funds are transferred to the United States.
Or, if economic growth prospects in Europe falter, investors may want to hold more U.S. stocks than European stocks, he said.
In this case, foreigners purchase financial assets denominated in U.S. dollars. Peterson said they would sell their own currencies and buy U.S. dollars, a process that would ultimately push U.S. dollar strength higher.
He said exchange rates “all come down to capital flows”.
He added that while these dynamics are also present in emerging markets, currency swings can be more volatile than in developed countries due to factors such as political shocks and commodity price risks such as oil.
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