Businesses pay nominal bilateral exchange rates. Those are what we trade. However, to understand the impact on the economy, it is best adjust for inflation and use a broad basket of currencies that match a country's trading partners.
The Federal Reserve tracks such an index for the dollar. At the end of every month, it calculates the real broad trade weighted measure. It May is fell by a little less than 1% after falling a little more than 1% in April. Over the past two months, it is depreciated by a little less than 2%.
Although the US has been traditionally a vocal advocate of free-trade, the external sector is relatively small for the US. One way to measure the external sector is to calculate exports plus imports as a percentage of GDP. It is less than 30% in the US. This means that the US economy is not particularly sensitive to movements in the dollar. The rule of thumb for a very open economy, such as Switzerland, for example, is that a four percent appreciation of the franc, is tantamount to a 1% tightening of monetary policy. In the US, the ratio is estimated closer to 10 to 1. That is a 10% appreciation of the broad trade weighted dollar has roughly the same impact as a 100 bp increase in the policy rate.
Since the real broad trade weighted dollar index put in its record low in 2011, it has appreciated by about 17.8%. The bulk has taken place since last July. Since then it has appreciated by almost 11% through March. Although the dollar tends not to be featured much in the setting of Fed policy, the sharp advance drew more attention from the officials. What is important is the change in the index not so much it level. The pace of the dollar's appreciation was not regarded as likely to be repeated and therefore, many regarded its negative impact on the US economy as transitory.
This Great Graphic, composed on Bloomberg, places the current appreciation of the real broad trade weighted dollar index in its historical context. It has not yet risen above the March 2009 high (~96.85). However, if this is going to be the third big dollar bull since the end of Bretton Woods as we have suggested, then it is still in the relatively early days.
A downtrend line drawn off the peak of the Reagan dollar rally and the Clinton dollar rally has not been taken out. In comes in near 100.60 this month and near 100.15 at the end of the year.
The Reagan dollar rally was fueled by the tight monetary policy and loose fiscal policy overshoot. Central bank coordinated intervention at the Plaza Hotel in September 1985 marked the end of the dollar rally. The Clinton dollar rally was fueled by the US tech bubble and capital inflows into the US equity market. The euro had birthing pains and fell to $0.8230 in 2000. Coordinated intervention helped the euro carve out a bottom.
The Obama dollar rally is being fueled by the divergence of monetary policy. The US seemed to respond earlier and more aggressively to the Great Finance Crisis than the eurozone and Japan. Whereas the Federal Reserve stopped its extraordinary monetary policy, the BOJ accelerated its policy, and the ECB launched a substantial asset purchase plan only three months ago.
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