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The Federal Reserve may start cutting interest rates before the end of the year. This could make future trips abroad more expensive for domestic travelers.
This is because of how interest rate policy affects the strength of the US dollar.
Here’s the gist: An environment of rising interest rates in the U.S. relative to those in other nations is generally “dollar positive,” said Jonathan Petersen, senior market economist and currency specialist at Capital Economics.
In other words, rising interest rates support a stronger US dollar against foreign currencies. Americans can buy more things with their money abroad.
The opposite dynamic β falling interest rates β tends to be “dollar negative,” Petersen said. A weaker dollar means Americans can buy less abroad.
Fed officials said in June they expect to cut rates once in 2024 and four more times in 2025.
“Our expectation right now is that the dollar will come under more pressure next year,” Petersen said.
However, this is not necessarily a foregone conclusion. Some financial experts believe the dollar’s strength may have staying power.
“There have been a number of headlines calling for a collapse in the US dollar,” said Richard Madigan, chief investment officer at JP Morgan Private Bank. He wrote in a recent note. “I continue to believe that the dollar remains the one-eyed man in the land of the blind.”
Why the US dollar gives a “discount” abroad
The Fed began aggressively raising interest rates in March 2022 to tame pandemic-era high inflation. By July 2023, the central bank had raised interest rates to theirs higher level in 23 years.
The dollar’s strength increased in this context.
The Nominal US Dollar Broad Index it is higher than at any point before the pandemic dating back to at least 2006, when the central bank began tracking such data. The index measures the dollar’s appreciation against the currencies of the country’s main trading partners, such as the euro, the Canadian dollar and the Japanese yen.
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For example, in July 2022, the US dollar reached parity with the euro for the first time in 20 years, meaning they had a 1:1 exchange rate. (The euro has recovered slightly since then.)
In early July, the US dollar took a hit stronger level against the yen in 38 years.
A strong U.S. dollar offers “a discount on everything you buy while abroad,” Petersen said.
“In a sense, it’s never been cheaper to go to Japan,” he added.
A record number of Americans visited Japan in April, according to the Asian country’s tourism board. Benjamin Atwater, communications specialist at InsideAsia Tours, a travel agency, attributes this in part to the financial incentive provided by the strong dollar.
In fact, he personally recently extended a work trip to Japan by a week and a half – instead of choosing to travel elsewhere in Asia – mainly because of the favorable exchange rate.
Everything from the meals, hotels, souvenirs and rental car was “a great value,” said Atwater, who lives in Denver and has long wanted to travel to Japan.
βIt was always portrayed as one of the most expensive places to go, [but] I was getting some of the best steaks I’ve ever had for about $12,β he said.
How interest rates affect the US dollar
In fact, the dynamics driving the dollar’s swings are more complex than whether the Fed raises or lowers interest rates.
The difference in U.S. interest rates relative to other nations is what matters, economists said. Fed policy does not exist in a vacuum: other central banks are also making interest rate choices at the same time.
The European Central Bank cut interest rates in June, for example. Meanwhile, the Fed has kept interest rates higher for longer than many forecasters expected – meaning the rate differential between the US and Europe has widened, helping support the dollar.
“The Fed is on hold, other central banks are preparing to ease, and the Bank of Japan (BoJ) looks stuck in a moment,” JP Morgan’s Madigan wrote.
Federal Reserve Chairman Jerome Powell speaks during a hearing of the Senate Banking, Housing and Urban Affairs Committee on July 9, 2024.
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“If Japan wants the yen to stabilize, policy rates need to move higher,” he added. “That doesn’t seem to be happening any time soon. With the ECB expected to cut ahead of the Fed, I expect the current euro weakness to prevail.”
That’s against the backdrop of a relatively strong U.S. economy, which also supports a strong dollar, Petersen said. At a high level, a strong economy means there will generally be higher economic growth and/or inflation, which means a greater likelihood that the Fed will keep interest rates relatively high, he said.
A strong economy also typically gives foreigners incentives to park more money in the U.S., he said.
For example, investors generally do better in cash when interest rates are high. If an investor in Europe or Asia was getting maybe 1% or 2% in bank accounts, while such U.S. holdings were yielding 5%, that investor could move some money to the U.S., Petersen said.
Or, an investor might want to hold more of his portfolio in U.S. rather than European stocks if the outlook for economic growth was not good in Europe, he said.
In such cases, foreigners buy financial assets in dollars. They would sell their local currency and buy the dollar, a process that ultimately increases the dollar’s strength, Petersen said.
Exchange rates “all come down to capital flows,” he said.
While this dynamic is also true in emerging markets, exchange rate movements can be more volatile than in developed countries due to factors such as political shocks and risks to commodity prices such as oil, he added.