Strong Dollar: A Headwind for Trade

A stronger U.S. currency likely will continue to weigh on exports and boost imports. What does this mean for future U.S. growth?

Dollar foreign-exchange gains have already had an impact on trade: exports have weakened and imports have risen. The reality is not as severe as some of the earlier, more inflammatory commentary suggested, but it is clearly evident that this situation will likely continue in coming months, even if, as expected, the dollar’s foreign-exchange value stabilizes. Buyers in many cases are still rethinking their supply arrangements. Later this year, the trade situation should face another phase of deterioration, as promised Federal Reserve interest-rate hikes renew dollar strength. These setbacks hardly threaten to derail the overall economy’s recovery, but they offer yet another reason why it will likely remain historically slow.

The Record So Far
The U.S. dollar began its rise about a year ago. Then its exchange rate was just less than $1.40/€1. The dollar hit its strongest at $1.05 to the euro this past spring, as the latest Greek crisis gained momentum. More recently, it has traded at about $1.10 to the euro, giving the dollar a gain to date against the euro of about 21% over the last 12 months. Europe, of course, is not the world. But what’s happening there is typical of what is happening elsewhere. Dollar gains against the Japanese yen and other currencies pushed the global dollar index up some 25% from midyear 2014 to its spring peak. Since then, the dollar has retrenched some, but only some 2.5% off its highs a few months ago.1

Because a strong dollar raises the cost of American goods and services relative to those abroad, such movements tend to detract from export growth and increase import flows. This now has happened. From their peak in October 2014, exports declined 4.6% through May (the most recent month for which data are available). With imports, the statistical record is muddier. Dollar strength—by raising American’s global purchasing power—would normally prompt more sourcing overseas. But because oil prices have fallen, in part because of dollar strength, imported oil, still a significant part of the mix, costs much less. So in aggregate, imports, after rising 4.4% from year-end 2013 to October 2014, have actually fallen 4.2% since. Take the special case of oil away, however, and the expected pattern appears. Imports ex-oil have risen 4.4% in the first five months of this year, compared with the year-ago period.2

Actually, these figures, even adjusted for oil, still produce a distorted picture. Because a rise in the dollar allows Americans to get more for their money abroad, a rise in the volume of imports appears less pronounced when measured in nominal dollar terms. The real or volume figures reported by the Commerce Department get away from this effect. They show an almost 5.0% rise in real imports from their lows about a year ago. At the same time, American exports, frequently paid in foreign currencies, garner a reduced nominal dollar amount as the dollar rises, leaving the nominal figures to overstate any real export decline. Again, the real or value figures offer a better perspective. They show a 2.4% drop in exports from last October’s peak. According to the Commerce Department, these effects, plus the unusual impact a West Coast dock strike had on trade, shaved 1.5 percentage points off the whole economy’s real growth rate during the six months from September 2014 to March 2015 (the most recent period for which data are available). The strike was the bigger influence. The currency effects probably came closer to shaving only 0.8% off the overall real growth rate.

Even if the dollar were to stabilize for a while (which actually is quite likely in the current milieu), this admittedly mild deterioration in the country’s trade situation will tend to continue. Many contracts have bound parties to trade arrangements made prior to the dollar’s move. As time passes, more and more of those contracts will expire, prompting importers and exporters to reassess and source more outside the United States. Even where contracts are not a factor, business decision makers often only reassess on the basis of cumulative pricing effects over an extended period, and they have yet to make their adjustments. These two considerations point to continued erosion in exports and increases in imports, extending the trends evident already in the data even if there were no further currency movement.

Matters will change again later in the year, when the Fed plans to raise interest rates. Policymakers, unsurprisingly, have left it up in the air when they plan to raise rates and by how much. Popular thinking in the financial community puts the first move in October or November, likely a 25 basis-point increase in the Fed’s benchmark fed funds rate. That is not an unreasonable expectation, though policymakers certainly are capable of waiting longer and raising rates by a smaller amount. Though increments of 25 basis points have become common, almost standard, the Fed has in the past implemented interest rate policy in 12.5 basis-point increments. The officials could do it again. Whatever the exact amount, they likely will follow the first move with more. After all, their goal, in their own words, is to “normalize” the situation, which, though the Fed has not defined the word, would likely involve a gradual effort to bring short-term interest rates even with the rate of inflation. However boldly they choose to proceed, the likelihoods still point to a first move this year or early in 2016, at the latest. They cannot wait much longer. Because they told the country they would begin this year, their credibility is at stake. Also, next year is an election year. Initializing a policy change in an election year always invites unwelcome accusations that the Fed is playing politics, which policymakers can avoid if they move long enough before the election.

Dollar gains will likely result. Higher rates in the United States, even if up only marginally, will attract short-term deposits from around the world, a flow that will increase the demand for dollars. Certainly, the Fed faces no competition on such moves. The European Central Bank’s need to cope with a financial crisis and the threat of deflation should prompt it to push rates lower rather than higher. The Bank of Japan, too, should resist any rate increase. Under so-called Abenomics, the central bank is committed to keep a sustained flow of yen liquidity into Japanese markets. Meanwhile, China and many other emerging market economies are pushing down rates in order to stimulate their economies under pressure of uncertainty and recent equity-market setbacks.

With the Fed’s move extending the dollar’s rise, the adverse effect on exports and tendency for imports to rise faster than they otherwise might will then likely stretch well into 2016. Especially since the expected currency moves from rate increases will likely develop on a gentler slope than the currency climb of the past year, these additional trade effects will likely be less pronounced than they have been over the past few months—except that with oil prices no longer in decline, that particular and powerful mitigating effect will fail to appear going forward. On balance, then, trade likely will have a smaller adverse impact on the economy’s overall real pace of growth than during the tail end of 2014 and earlier this year. A reasonable expectation is that this will shave perhaps half a percentage point off the overall growth rate of real gross domestic product—not enough, certainly, to raise recession concerns but quite enough to keep the overall pace of the recovery slower on average than historical standards, something probably in the range of 2–2.5%.

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