Changes in the federal funds rate can impact the U.S. dollar. When the Federal Reserve increases the federal funds rate, it typically increases interest rates throughout the economy. The higher yields attract investment capital from investors abroad seeking higher returns on bonds and interest-rate products.
Global investors sell their investments denominated in their local currencies in exchange for U.S. dollar-denominated investments. The result is a stronger exchange rate in favor of the U.S. dollar.
Key Takeaways
- When the Federal Reserve increases the federal funds rate, it typically increases interest rates throughout the economy, which tends to make the dollar stronger.
- The higher yields attract investment capital from investors abroad seeking higher returns on bonds and interest-rate products.
- Increases or decreases in the fed funds rate have correlated fairly well with moves in the U.S. dollar exchange rate versus other currencies.
Understanding the Fed Funds Rate
The federal funds rate is the rate banks charge each other for lending their excess reserves or cash. Some banks have excess cash, while other banks might have short-term liquidity needs. The fed funds rate is a target rate set by the Federal Reserve Bank and is usually the basis for the rate that commercial banks lend to each other.
However, the fed funds rate has a far more sweeping impact on the economy as a whole. The fed funds rate is a key tenet of interest rate markets and is used to set the prime rate, which is the rate banks charge their clients for loans. Also, mortgage and loan rates, as well as deposit rates for savings, are impacted by any changes in the fed funds rate.
To combat inflation that started increasing in 2021, the Fed began raising interest rates. It raised rates from a target of 0.25% to 0.50% in March 2020 to a target of 5.25% to 5.50% in July 2023, which was the last time it increased rates.
The Fed, through the FOMC or Federal Open Market Committee, adjusts rates depending on the economy's needs. If the FOMC believes the economy is growing too quickly, and inflation or rising prices might likely occur, the FOMC will increase the fed funds rate.
Conversely, if the FOMC believes that the economy is struggling or might dip into a recession, the FOMC would lower the fed funds rate. Higher rates tend to slow lending and the economy, while lower rates tend to spur lending and economic growth.
The Fed's mandate is to use monetary policy to help achieve maximum employment and stable prices. During the financial crisis of 2008 and the Great Recession, the Fed held the federal funds rate at or near 0% to 0.25%. In the following years, the Fed increased rates as the economy improved.
Inflation, the Fed Funds, and the Dollar
One of the ways the Fed achieves full employment and stable prices is by setting its inflation target rate at 2%. In 2011, the Fed officially adopted a 2% annual increase in the price index for personal consumption expenditures as its target.
In other words, as the inflation component of the index rises, it signals that the prices of goods are rising in the economy. If prices are rising, but wages aren't growing, people's purchasing power is declining. Inflation also impacts investors. For example, if an investor is holding a fixed-rate bond paying 3% and inflation rises to 2%, the investor is only earning 1% in real terms.
When the economy is weak, inflation falls since there's less demand for goods to push up prices. Conversely, when the economy is strong, rising wages increase spending, which can spur higher prices. Keeping inflation at a growth rate of 2% helps the economy grow at a steady pace and allows wages to naturally rise.
Adjustments to the federal funds rate can also affect inflation in the United States. When the Fed increases interest rates, it encourages people to save more and spend less, reducing inflationary pressures. Conversely, when the economy is in a recession or growing too slowly, and the Fed reduces interest rates, it stimulates spending spurring inflation.
How the Dollar Helps the Fed With Inflation
Of course, many other factors impact inflation besides the Fed. The U.S. dollar exchange rate plays a role in inflation. For example, as U.S. exports are sold to Europe, buyers need to convert euros to dollars to make the purchases.
If the dollar is strengthening, the higher exchange rate causes Europeans to pay more for U.S. goods, based solely on the exchange rate. As a result, U.S. export sales may decline if the dollar is too strong.
Also, a strong dollar makes imports cheaper. If U.S. companies are buying goods from Europe in euros and the euro is weak, or the dollar is strong, those imports are cheaper. The result is cheaper products at U.S. stores, and those lower prices translate to low inflation.
Cheap imports help keep inflation low since U.S. companies that produce goods domestically have to keep their prices low to compete with cheap imports. A stronger dollar aids in making imports cheaper and acts as a natural hedge for reducing inflation risk in the economy.
As you can imagine, the Fed monitors inflation closely along with the level of strength of the dollar before making any decisions regarding the fed funds rate.
Note
The prime rate is the rate that affects other interest rates in the economy. The fed funds rate, set by the Federal Reserve, is the basis for the prime rate. The prime rate is the rate at which banks lend money to their most creditworthy customers.
Timeline of the Fed Funds and the U.S. Dollar
Below we can see the fed funds rate since the mid-1990s; the gray areas denote recessions:
- In the mid-1990s, the fed funds rate rose from 3% to eventually over 6%.
- The fed funds rate was lowered in 2001 to 1% from over 6% a year earlier.
- In the mid-2000s, the fed funds rate was hiked with an improving economy.
- In 2008, the fed funds rate was lowered again from over 5% to nearly zero and stayed at zero for several years.
- As the economy recovered from the Great Recession, the Fed gradually raised rates until 2018.
- With the fallout from the COVID-19 pandemic, the Fed took emergency measures to lower rates to keep the economy afloat.
- The economy emerged from the COVID-19 pandemic amid widespread vaccination. However, inflation rose dramatically.
- Inflation started to increase in 2021 and surged in 2022, hitting a peak of 9.1% as measured by the Consumer Price Index (CPI) in June 2022.
- In response to the surging inflation, the Fed raised interest rates for the first time since 2018.
- As inflation remained high, the Fed continued to increase interest rates throughout 2022 and 2023. As of Dec. 2023, inflation has come down significantly, sitting at 3.4%.
:max_bytes(150000):strip_icc()/Screenshot2024-01-26at3.26.59PM-a4d51313844b4616a01dbbda4bb3b419.png "How Moves in the Fed Funds Rate Affect the U.S. Dollar (1)")
Source: Federal Reserve Bank of St. Louis.
As the fed funds rate increases, overall rates in the economy rise. If global capital flows are moving into dollar-denominated assets, chasing higher rates of return, the dollar strengthens.
In the chart below, we can see the moves in the U.S. dollar over the same period as the rate hikes in the earlier graph.
- In the mid-1990s, when the fed hiked rates, the dollar rose as measured by the dollar index, which measures the exchange rates of a basket of currencies.
- In 2002, when the Fed cut rates, the dollar weakened dramatically.
- The dollar correlation to the fed funds broke down somewhat in the mid-2000s. As the economy grew and rates rose, the dollar didn't follow suit.
- The dollar began to rebound only to fall again in 2008 and 2009.
- As the economy emerged from the Great Recession, the dollar fluctuated for years.
- Against the backdrop of a stronger economy and eventual Fed hikes, the dollar began to rise again from 2014 to 2017, stabilizing until the Spring of 2020.
- The dollar saw a spike in 2020 amid the global COVID-19 pandemic, as investors sought stability. As the world's economies emerged from the pandemic, the dollar gradually weakened from its record-high levels.
- In 2021 and 2022, the dollar again began approaching record-high levels amid rate hikes from the Fed.
- Rate hikes continued to increase in 2023 but not at the same level or frequency, which saw the real dollar broad index drop and remain flat.
:max_bytes(150000):strip_icc()/Screenshot2024-01-26at3.28.27PM-f28265f3daa943a08f56c62cd8cdc765.png "How Moves in the Fed Funds Rate Affect the U.S. Dollar (2)")
Source: Federal Reserve Bank of St. Louis.
What Is the Inflation Target?
The Federal Reserve maintains an inflation target of 2% over the longer run as it believes that number is most consistent with the Fed's mandate to ensure maximum employment and price stability.
How Do Interest Rates Reduce Inflation?
Rising interest rates reduce inflation by making goods and services more expensive. Inflation is an overall increase in prices. To reduce prices, demand must be reduced. By making goods and services more expensive, consumers will purchase less, thus reducing demand and curbing inflation.
Rising interest rates make goods and services more expensive because when consumers borrow on credit, having to pay interest, such as on a loan or credit card, a higher rate means it costs more.
What Is the Difference Between Monetary Policy and Fiscal Policy?
Monetary policy is enacted by a country's central bank and involves controlling the money supply. Fiscal policy is enacted by a nation's government and involves controlling taxes and government spending.
The Bottom Line
In general, and under normal economic conditions, increases in the federal funds rate lead to higher rates for interest rate products throughout the U.S. The result is usually an appreciation of the U.S. dollar.
Of course, the correlation between the fed funds rate and the dollar can break down. Also, there are other ways that the dollar can weaken or strengthen. For example, demand for U.S. bonds as a safe-haven investment in times of turmoil can strengthen the dollar independently of where interest rates are set.
