Break in the Clouds for Fed

As the Fed prepares for its two-day policy meeting on July 26 and July 27, the news has not been great. Inflation, as measured by the Consumer Price Index (CPI) shows that in June, prices were up 9.1 percent from a year ago. And because inflation is regressive, meaning that it hurts lower earners more dramatically than all others, many Americans are struggling. But there may be a few breaks in the cloudy economic picture for our central bankers.

The most important factor in the headline rate, and the one we all complain about is energy. Crude oil may have peaked in June at $123 and is now hovering at around $100. The drop in the raw commodity has eased some of the most acute pressure at the pump, with prices down by 60 cents a gallon, as of this writing. Amazingly, we may soon be cheering $4/gallon gas in the coming months.

Also helping the Fed is the rise of the U.S. dollar, which is the strongest it’s been in 20 years. The dollar’s renewed fortune is directly linked to rising interest rates. Standard economic theory posits that when the Federal Reserve raises short term rates more quickly and by more than other central banks around the world, the dollar rises in value. To date, the Federal Reserve has raised interest rates by 1.5 percent, with another 0.75 percent likely at the July meeting, while the European Central Bank announced its first rate increase in twenty years, 0.50 percent.

Finance folks say that higher interest rates make the return on savings more attractive in the U.S. than in other countries. Then as capital from around the world flows into the U.S., the dollar rises even more. Some economists doubt this linked effect, but I’ll let the PhDs quibble over the mechanism. For today, let’s figure out what the rising dollar means for the economy and for you.

The winners of a strong dollar start with American tourists, who are traveling abroad. When the U.S. dollar rises in value compared to foreign currencies, Americans get more bang for their buck when they are in London, Paris, or Japan. The couple from Chicago may even feel like the inflation fears they faced at home aren’t so bad, after factoring in the exchange rate. As a result, they may splurge for a new handbag, belt, or shoes. Those purchases may boost the bottom line of sellers of those types of goods. The stronger dollar may also help ease the pain at the pump, because crude oil is priced in dollars.

But with every winner, there is also a loser. In the case of a strong dollar, countries that have a lot of debt that is denominated in dollars (which is much of the developing world, including big countries like Argentina and Turkey), the cost of servicing that debt rises as the value of the dollar increases. And since oil is a global commodity, the cost of a liter of gas in Berlin, Brittany, or Barcelona, just got even more expensive with the dollar’s surge.

Finally, there’s the problem of the U.S. company that does a lot of business abroad. A strong greenback makes everything from an iPhone to a Microsoft software package to Costco store products less compelling when compared to a local brand that is now cheaper, due to the exchange rate. Therefore, U.S. multinationals could see margins compressed, which could eat into profits and cause their stock prices to drop.