A key question for the Federal Reserve in the months ahead will be the U.S. dollar’s future direction. That question will have a crucial bearing on the appropriate timing of the start of the Fed’s interest rate hiking cycle. If it is thought that the dollar’s recent strengthening is likely to be reversed, the Fed would be advised to start raising interest rates soon for fear of allowing domestic inflationary pressures to build up. By contrast, if it is thought that the dollar might very well add to its recent gains, the Fed would be advised to exercise patience before hiking rates for fear of setting back the economic recovery.
The relevance of this issue is underlined by the dollar’s recent strength. Over the past six months, the dollar has appreciated by around 15 percent against a basket of currencies, making this the second steepest rise in so short a period since the dollar’s floating began some 40 years ago. If sustained, such a rise could materially alter the U.S. economic outlook. Indeed, according to International Monetary Fund (IMF) estimates, if the past year’s gain in the U.S. dollar is sustained, one could expect U.S. gross domestic product (GDP) growth to be around 1 percent lower than it would otherwise have been. Similarly, one could expect U.S. inflation to be around 1 percent less than otherwise would have been the case. Together with lower international oil prices, a strong dollar could very well contribute to a negative U.S. headline inflation rate before year-end.
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