Among the various factors that play an important role in the policymaker's decision to increase interest rates, the dollar and its impact on exports is a key consideration. This article underscores the importance of dollar movement on export-driven growth and the key factors that will prevent the Fed from increasing interest rates if the dollar remains relatively strong.
Using charts is the best way to explain any point in finance and economics, and the chart below (from 1995 to 1Q 2016) gives the trade weighted US dollar index plotted with US exports as a percentage of GDP.
It is very clear from the chart that as the dollar strengthens against key trading partner currencies, the negative impact on exports is significant and this translates into weaker net exports contribution to GDP growth.
In particular, the trade weighted dollar index has strengthened in the last 12 months and this has impacted export-driven growth. While the dollar index has weakened in the recent past, any rate hike will ensure renewed dollar strength and weak exports. Further, the economy has hit a soft patch and that should delay a rate hike.
To further elaborate on the importance of the exports sector for the US economy, I will use some points from the Economic Report Of The President for 2016. According to the report, exports support nearly 12 million jobs in the United States and exporters pay 18% higher wages (on an average) than non-exporters.
Importantly, the US is a consumption based economy, and I believe that there needs to be a higher focus on production and exports. The Trans-Pacific Partnership is important from the perspective of boosting exports, but it does require support from a relatively weaker dollar.
As the dollar index has witnessed some weakness in the recent past, policymakers will hope that this translates into incremental net exports contribution to GDP growth in 2Q 2016 and beyond. In my view, the Fed will hold rates steady through 2016 or potentially cut rates in the second half of 2016 to boost stimulus and export-driven growth.