By Sarah Greene, lecturer in economics
This year, we’ve all experienced the effects of inflation at the gas pump and the grocery store and we hear that the Fed is trying to control this inflation by raising interest rates. Many of us may struggle to understand what a climate of rising interest rates means in terms of risks and benefits. But there’s at least one way to take advantage of the situation, and it doesn’t involve currency speculation. To understand, let’s first state some of the basics.
We know that the current inflation has been caused by a multifaceted collection of national and global issues affecting supply and demand, but there is one single entity responsible for raising interest rates — the Federal Reserve. Raising interest rates is the primary mechanism of a policy called monetary tightening, which is intended to combat inflation by reducing the quantity of money circulating in the economy and in turn, dialing back domestic spending. However, the increased interest rates also have repercussions around the world as foreign financial investors become attracted to securities (interest-bearing assets, such as bonds) issued by American firms because they now offer higher yields. As foreign investors flock to these dollar-denominated securities, we see changes in exchange rates between the United States Dollar (USD) and foreign currencies. In fact, differentials in interest rates paid on financial securities between countries are the main drivers of fluctuations in currency exchange rates.
The result of these dynamics, which are unfolding as the Fed raises rates to combat inflation, is an uncommonly strong USD relative to other currencies. For example, the exchange rate between the yen and the USD is roughly 138 yen/USD as I write this. Just one month ago, the rate was 136 yen/USD. What this means is that, for people in Japan, it now costs more yen to purchase one USD. In other words, the yen has depreciated. For people in the United States, a single USD now buys more yen than before. The dollar has appreciated, and this means greater purchasing power of the dollar in other countries.
All told, the current climate of the American economy — inflation, rising interest rates, and an appreciating dollar — has created favorable conditions for Americans to travel abroad. Hotel stays, admission fees, food, and other goods will essentially cost less because the purchasing power of the USD is now greater than it was before interest rates began to rise within the United States.
We can not only expect these conditions to remain in place, but to become even more favorable, because the USD will continue to strengthen if the Fed keeps raising rates. Given that inflation is still much higher than the goal of 2%, we should expect the Fed to continue its policy of monetary tightening through the end of the year, and quite possibly longer.
It might be time to book that ticket.