Butterfly Effect of Strong U.S. Dollar

       The U.S. dollar has been appreciated by 15% last 6 months. This strong dollar, along with other monetary policies, effect on U.S. economy. Among others, it was the major cause of real interest rate increase.

Figure 1 U.S. dollar currency index for last 6 months. It has been appreciated by 15% during the period.
Source: CNBC.com

The strong dollar doesn’t directly effect on real interest rate. However, low oil price is related with high U.S. dollar, and this low oil price hits the economy hard by lowering price level. The Fisher Equation states that decline in price level lowers inflation rate; therefore increases real interest rate while nominal interest stays the same.

U.S. dollar is commonly used in commodity market, especially for crude oil. Appreciation in dollar drops cost of oil. The oil supplier, like Saudi Arabia, needs to increase supply to keep the same level of revenue, which decreases oil price further. Other geopolitical issues and international monetary policies like threaten from Islamic State, and quantitative easing from Bank of Japan and European Central Bank also strengthens dollar therefore declines oil price.

As oil price declined, both Consumer Price Level (CPI) and Manufacturing Purchasing Manager Index (PMI), which shows confidence of manufacturing sector, drop.

Figure 2 Purchasing PMI of Germany and United States.
Source: Tradingeconomics.com

Figure 3 Change in inflation for United States and Eurozone.
Source: Tradingeconomics.com

Even though Federal Reserve Bank has kept nominal interest rate almost 0 since 2011 to boost consumer spending and private investment, increase in real interest rate makes Fed hard to achieve the goal. It means industries experience higher real interest rate even though nominal interest rate has been low for a long time. It becomes a burden for industries.

Figure 4 Real interest rate of United States
Source: FRED

This burden is shown in 4th quarter GDP. On January 30th, GDP of U.S. rose by 2.6%; compared with 5.0% increment in 3rd quarter. Weaken in investment stood out that Nonresidential Fixed Investment declined by 0.8%, and Nonresidential Structure Investment dropped by 7.8%. Even Real Residential Fixed Investment fell by 5.6%, which shows weaken housing market. Besides, below-expected company earnings in 4^th quarter is likely decline further investment.

So, there’s a voice arising whether the Fed should increase interest rate in a ‘considerable time.’ Increase in nominal interest rate may discourage investment, which worsens company’s earning. Yet the Fed may say the market is too overwhelmed that exit plan is needed. The Fed said that they will look at Personal Consumer Expenditure rather than company’s earning to decide interest rate, but the Chairwoman Yellen also wants to oversee financial market to reduce its impact.

Meanwhile, expected consumer inflation rate is at 2.8%, where the Fed may not deeply concern about the real interest rate. Expected real interest rate is at negative level that high expected interest rate would increase consumer spending. The Personal Consumption Expenditure shows continuous increment after the Great Recession.

Figure 5 Expected Real Interest Rate of United States.
Source: Federal Reserve Economic Data

Figure 6 Personal Consumption Expenditures of United States. The gray area is where the Great Recession is.
Source: Federal Reserve Economic Data

While labor market improves, increase in interest rate seems inevitable; it is matter of time. This high real interest rate came from strong dollar. The strong dollar drops oil price, which directly impacts on the economy. Along with labor market and consumer spending improvement, the Fed is likely increase interest rate in a considerable time. Companies need to be cautious for better debt control and investment.