Three months ago, nothing could stop the dollar.
It had shot up 23 percent the 18 months before against a broad basket of currencies, and it looked like that was only going to continue. Which, of course, is when it stopped. Indeed, the dollar has fallen almost 5 percent since the end of January, and now that is what looks like is only going to continue.
So in other words, not long ago you could expect to travel abroad this summer and get a lot for your dollar. Now, not so much.
What’s going on?
Well, to paraphrase noted currency expert Robert Frost, two monetary policies have not diverged in a wood (or anywhere else for that matter) as much as people expected them. Since the middle of 2014, you see, investors have been betting that the Federal Reserve would start increasing interest rates at the same time that the rest of the world would be cutting them or even printing money. Which is just another way of saying that they thought the dollar would go up. Think about it like this: capital goes where it can get the best return. So when German 10-year bonds are paying 0.16 percent and U.S. 10-year bonds are paying 1.75 percent, investors, especially big European ones, are going to move their money out of euros and into dollars. And that, in turn, means there’s more demand for dollars, so their price goes up.
That, at least, is what markets thought was going to happen at the start of the year. It seemed so straightforward. The Fed had just raised rates for the first time in nearly a decade, and Fed Vice Chair Stanley Fischer said it hoped to do so four more times in 2016. Meanwhile, Europe and Japan were both cutting rates even further into negative territory, and printing money with no end in sight. The result is that investors pushed the dollar up to a 13-year high in anticipation of all this continuing.
But a funny thing happened on the way to more rate hikes. The economy started to look a lot less certain. Sure, it was still adding the same 200,000 jobs a month it has been most of the recovery, but markets sold off so much that they seemed to be saying the good-ish times were coming to an end. And even if that wasn’t completely the case, it was enough of it when the economy only grew a piddling 0.5 percent in the first quarter. It’s not a recession, but it doesn’t have to be for higher interest rates not to make any sense.
It didn’t take long for markets to go from thinking the next rate hike would be in March to maybe June and then more likely September or December - if at all. So much for raising rates four times this year. Or for the dollar going up anymore. In fact, it has done the opposite.
That brings us to our Catch 22. The only way to get rid of zero interest rates when the rest of the world has them is to not try to get rid of them. That keeps your currency cheap, boosts your exports as a result, and just might give you such strong growth that higher rates are more than justified. But if you hike rates prematurely, markets will send your currency soaring, your exports will slump, and your economy will slow down enough that you need to keep rates lower.
In other words, just talking about raising rates is the new raising rates. Now, that doesn’t mean you can’t raise them at all — the Fed has, after all — just that it’s going to take a long, long time. First, you have to say you’re going to increase interest rates, and then you have to wait for markets to think that’s okay. Then once you do, you have to wait again for markets to think it’s OK to even go back to talking about it. Rinse and repeat. So that turns the dollar into a little more of a yo-yo than usual: up whenever the Fed is trying to raise rates, and down whenever it realizes that trying has made it so it doesn’t need to for now. So the dollar might not keep going up, up, up, but instead go up, down, up, down, and up again.
It isn’t as easy for paths to diverge as it used to be.
- Matt O’Brien is a reporter for The Washington Post’s Wonkblog covering economic affairs.
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