On Monday, the U.S. dollar reached its highest level in a year and a half, as measured against a weighted basket of foreign currencies. You can now buy a Euro for just $1.12, and a British pound for $1.28.
So, it’s a good time for a European vacation. But what else does this mean? Here are a few takeaways:
The strong dollar is a sign of America’s relatively good economic outlook. When a country is expected to have stronger growth than its peers, its currency tends to rise because people want to make investments in that country, and you need that country’s currency in order to do so. Conversely, economic challenges can worsen the investment outlook and reduce the demand for local currency. Political-economic turmoil in Europe — such as Brexit and the fight between Italy and the rest of the EU over its budget — have tended to push the Euro and the pound down, relatively strengthening the dollar.
The strong dollar reflects expectations that the Federal Reserve will continue to raise interest rates. When rates go up, that makes it attractive to own U.S. government bonds, and people need dollars to buy those bonds, so the dollar strengthens when rates are expected to rise. This is one of the reasons President Trump has been so mad at the Fed: Their actions are causing the dollar to strengthen, and that undermines one of his other policy goals …
The strong dollar tends to grow the trade deficit. A strong dollar makes U.S. exports more expensive for foreign consumers, while making it more attractive for Americans to buy imported goods. A price drag on our exports is not weighing too much on the U.S. economy right now because domestic demand is strong (though the harm to exporters from a strong dollar may be one reason stocks are struggling). But Trump’s stated desire that the U.S. should cease having a trade deficit is undermined by the dollar’s strength. That said…
Some of Trump’s own policies have strengthened the dollar. In particular, this year’s big tax cut has moved the dollar up in a couple of ways. One, by providing a short-term growth boost by raising the deficit, Trump has goosed the dollar-strengthening effect I described in the first bullet. And two, by lowering corporate tax rates and therefore increasing the after-tax rate of return on investments, Trump has encouraged foreign investment in the U.S. That tends to strengthen the dollar, because foreigners need to obtain dollars to make those investments.
As the economist Jared Bernstein has noted previously, there has tended to be too much of a strong-dollar bias in U.S. policy-making. A strong dollar is not necessarily “better” than a weak dollar; it depends on the context. In a recession, a weak dollar might be a good thing, because it would foster exports and help Americans get back to work.
But right now, the dollar is strengthening mostly for good reasons that reflect U.S. economic strength — though the additional borrowing that was used to finance the tax cut is a worrying phenomenon, which trades somewhat higher economic growth now for slower economic growth a few years in the future.