The central bank of the United States, aka the Federal Reserve System or “Fed”, has what is known as a dual mandate. It is charged with keeping inflation in check and maintaining a strong jobs market (low unemployment). In this article, we’ll explore the Fed’s rate hike history and its impact on the US Dollar and foreign currency markets overall.
The most direct and immediate way the Fed affects the dollar is through interest rates. The Fed's Open Market Committee (FOMC) sets the federal funds rate, which is the interest rate at which banks lend reserves to each other overnight. In pursuing its inflation target (historically 2%), the Fed may adjust its monetary policy. If inflation rises above the target, the Fed may tighten monetary policy by increasing interest rates. This could lead to a stronger dollar as higher interest rates attract foreign capital seeking better returns. Conversely, if inflation remains low or falls below the target, the Fed might lower interest rates to stimulate economic activity, potentially weakening the dollar. The cyclical nature of Fed policy is integral to understanding Fed rate hike history.
Correlations Between Fed Policy and the Price of the Dollar
Short Term Dollar Reaction to Fed Policy Change
Eight times a year the Fed has monetary policy meetings, each of which ends with the FOMC releasing a statement updating conditions from the previous meeting, and stating what, if any, changes have been made to interest rates. In recent years the Fed has been clear in setting accurate expectations for policy through what is known as “forward guidance”. That means that the markets are rarely surprised by the release of the post-meeting statement. It is the relatively rare unexpected messaging that can cause a sharp reaction in FX markets. On December 13, 2023 Fed Chair Powell unexpectedly announced that “we believe that our policy rate is likely at or near its peak for this tightening cycle.” This shift from his previously stated commitment to “higher for longer” caused a sharp two-day drop in the dollar.
Forex markets also will also react to news that is expected to influence future Fed policy. An example would be the Nov 14, 2023 release of the US Consumer Price Index indicating lower-than-expected inflation. The dollar (DXY) dropped 1.5% in a single day as markets reacted to the evidence of disinflation and its potential effect on Fed policy.
The short-term reaction to news does not necessarily translate into sustained directional movement for the dollar unless market participants see the news as indicative of a significant policy change.
Longer Term Dollar Reaction to Fed Shifts
The dollar’s movements over the days and weeks after an FOMC meeting do not have a particular correlation with Fed activity. Many of the flows in currency markets are not sensitive to small adjustments in short-term interest rates.
The dollar’s rally during 2021-22 was largely triggered by the Fed’s exit from near-zero interest rates implemented to stimulate an economy slowed by the effects of the pandemic. The US economy generally outperformed its global peers during this time, encouraging flows into the US dollar. Note that in 2021 the dollar was near the low end of a 5-year trading range, so some of the appreciation could be attributed to to technical factors.
During the Fed’s tightening cycle of 2004-2006 the dollar lost ground to major currencies, particularly against the euro. That cycle came amidst the backdrop of the euro’s rebound from depressed levels following the introduction of the common currency. The Fed’s tightening in 2017-2019 resulted in initial dollar appreciation, but the greenback gave back most of its gains by the end of the cycle. These two examples illustrate that interest rate increases do not always result in a stronger dollar.
Current Technical State of the Dollar
After touching 20-year highs in October 2022 the dollar trended lower before establishing a low of 99.57 in July 2023. It then moved higher until October, reaching 107.34 before selling off at the end of the year. The net change for 2023 was a loss of just over 2%. Technicians will be watching the extremes of 2023 (107.34 and 99.57) for clues to the next big trend in the dollar. A violation of those levels would suggest a longer-term directional move.
Risk managers should be aware that interest rates are one of many factors that can affect the price of the dollar. Economists are currently split in their views on the dollar as 2024 begins, with most expecting depreciation largely due to the Fed’s recent dovish policy shift. The relative performance of the US economy compared to other nations will undoubtedly affect the dollar this year, as will domestic and international political events. Any expansion of strife in Ukraine or the Middle East or the outbreak of new hostilities in other regions could also affect flows into(or out of) the dollar.
Risk managers should anticipate that 2024 will be a volatile year in FX markets. The Fed and other central banks are expected to generally reduce interest rates during the course of the year, but the timing and magnitude of any cuts remain highly uncertain. Economic growth in each country will be a major determinant of its central bank’s policy, so it is probable that some currencies will gain against the dollar while others will drop. Now is a good time to do a thorough analysis of FX risk and create a plan to minimize any adverse effects of currency fluctuations.
