After 7 decreases in the federal funds rate the Fed may stay put for a while. The latest statements by Chairman Ben Bernanke seem to indicate that the Federal Reserve will put a hold on its expansionary monetary policy and will keep the rate at 2%. We should remember that this rate has fallen from 5.25% to 2% in a relatively short time. Since the European Central Bank has maintained its rates, it is clear that this has played a key role in the weakness of the dollar in recent months.
Bernanke has indicated that even though there are still elements that will tend to keep economic growth at low rates, there is also an increasing concern about inflation, and about a weak dollar, two things that are clearly related. So following the traditional approach of the Fed, we can expect that rates will remain at 2% for some months. It is not likely, given the low growth, that there will be increases in interest rates in the near future, although some analysts think that this may occur before the end of the year. In order for this to happen, however, inflation pressures would need to decrease and growth resume at higher rates.
So, what are the implications in terms of the strength or weakness of the dollar? Economic theory, and the real world, show that interest rate differentials are a very important factor in exchange rate variations. Very low interest rates produce capital outflows in search of a higher return elsewhere, thus depreciating your currency and appreciating the currency of the country that receives these flows. The recent depreciation of the dollar is a good example of this. And until recently some analysts were predicting that the dollar could further depreciate to approximately 1.7 dollars per euro. However, with the latest news this does not seem to be the case.
If the Fed maintains rates, the interest rate differential will not increase, and therefore, at least in this respect, there is no reason for the dollar to continue to debilitate in relation to the euro. This is why we might have already seen the minimum level of the dollar in relation to the euro in the medium term. Now there are more reasons to believe that the dollar may appreciate slightly in relation to the euro. However, let’s not expect a rally of the dollar in the short term. This rally may occur later in the year or at the beginning of the next one, once the Fed starts increasing its rates, and not when it just keeps them constant. But, given the instability in exchange rate markets, and the importance of expectations, we might start seeing a more favourable trend for the US currency. Many exporters in Europe will probably be happy to see this change in trend.