The Federal Reserve was established in 1913 to function as of the central bank of the United States and the key arbiter of its monetary policy systems. The Fed’s vital role is to regulate the supply of money and credit in an effort to maintain price stability and promote sustainable economic growth throughout the country.
In its regular courses of action, the Federal Reserve can use interest rate policy strategies to achieve these objectives and the Federal Open Market Committee (FOMC) is the body that ultimately determines the country’s base interest rate level (also known as the federal funds rate, or EFFR).
Impact on the U.S. Economy
The federal funds rate deeply affects America’s economy and can have a significant impact on the global financial system. An increase in the federal funds rate typically brings an increase in the value of the U.S. dollar, which is measured in three different ways:
Prevailing interest rates greatly influence the potential for strength or weakness in the U.S. dollar. A strong greenback should be of concern to the Fed for a variety of reasons. The majority of international trade is U.S. dollar-denominated and a rise in the value of the U.S. dollar implies that imports into the country will be cheaper. This is because U.S. residents get an opportunity to purchase foreign goods (or to make international trips) at lower relative prices.
However, most U.S. manufacturers and multinational organizations tend to be against a strong dollar policy at the Fed. Rising market valuations in the greenback make American products more expensive (less competitive) in the international marketplace. As a result, demand for U.S. goods decreases due to high prices. From the Fed’s perspective, low demand and reduced revenues in the manufacturing sector can lead to increased levels of unemployment.
In the U.S. business economy, the technology and pharmaceutical industries have a heavy presence out of the country and they can be negatively impacted by a strong dollar. In 2015, many U.S. companies (including Microsoft, Bristol-Myers Squibb, and Procter & Gamble Co.) released earnings reports showing that the strong dollar had adverse effects on sales of up to five percentage points each year. These figures can equate to substantial amounts of money when we consider the expansive market cap of these organizations.
Impact on the Global Economy
After remaining weak in the year 2017, the U.S. dollar started gaining strength in 2018 and this trend has continued throughout 2019. A high U.S. dollar exchange rate has the potential to slow down trade activities in the rest of the world. In other words, as the greenback strengthens, currencies used by many of the country’s trading allies begin to weaken.
Since the majority of international trade and investment transactions are conducted using the U.S. dollar, a rise in the US dollar can significantly impact demand for many different products and commodities. Moreover, countries doing U.S. dollar-denominated business will find it expensive to borrow the greenback in order to finance their international trade. As a result, a strong dollar restricts global financial flows, thereby slowing aggregate global trade activities.
In 2015, the strong value of the dollar had adverse effects on the eurozone. In response, the European central bank (ECB) was forced to initiate a quantitative easing plan to jumpstart the stagnating economy. Other evidence of the trend’s impact could be seen in countries like Australian and Chile, where the price of important exports commodity like copper experienced steep declines.
The Fed plays a crucial role in both the U.S. and world economies and its voting members must find a perfect balance between changing interest rate levels and the value of the currency. A too-strong dollar has certain benefits but also impacts the economies of many nations. As a result, the FOMC plays a critical role in defining global economic trends.