December 13, 2016

Interest Rates, the Dollar, and US Trade Flows

Series Information

This essay is the eleventh in a twelve-essay colloquium on the effect of low interest rates on the economy. To read other essays in the series, click here. 

US monetary and trade policies may seem to be disconnected disciplines, but they are bound together by the transmission belt of the dollar’s value in foreign currency markets. Whether US interest rates are low or high will affect US trade accounts along with the domestic economy.

Since the Great Recession of 2008–09, the Federal Reserve has followed both an extraordinarily easy monetary policy of low interest rates and the massive repurchase of Treasury bills. This expansionary policy has affected the global value of the US dollar and trade flows through two primary channels: a price effect and an income effect.

First, a lower domestic interest rate in the United States raises the price of Treasury bills, making them relatively less attractive to foreign investors. This lack of attractiveness reduces demand for the US dollar as global savers look elsewhere for better returns, putting downward pressure on the exchange rate. A cheaper dollar makes imports more expensive and less attractive in the American market while stimulating demand for US exports, thus moving the current account balance in a “positive” direction.

Second, to the extent that a lower interest rate stimulates economic growth, it will promote imports, as US consumers spend their extra income on domestic as well as foreign-made products and services. On the investment side, more robust growth will tend to attract foreign investment to the private economy through direct investment as well as portfolio investment in US equities. Thus, the income effect of lower rates will tend to push the trade balance in a “negative” direction while increasing net financial inflows, partially or wholly offsetting the price effect.

Tighter monetary policy will exert the opposite effect on the dollar and the current account balance. A 200–500 basis point increase in bellwether rates would raise foreign demand for Treasury bills and corporate bonds, thereby stoking demand for US dollars in the foreign exchange market. An appreciating dollar would stimulate imports and dampen exports, thus expanding the US trade deficit. But if the higher rates slowed the economy, that change would mitigate some or all of the price effect by reducing demand for imports and by reducing the inflow of foreign investment to the private sector.

The nexus of monetary and trade policy exposes one of the internal contradictions of president-elect Donald Trump’s economic program. His economic team has a stated goal of reducing and even eliminating the US current account deficit, which will reach about $500 billion in 2016. His advisors have also laid out ambitious plans to stimulate US economic growth through corporate tax reform and massive spending on infrastructure, just as the Federal Reserve Board is about to embark on a long-expected ratcheting of domestic interest rates.

The combination of looser fiscal policy and tighter monetary policy also characterized the early years of the Reagan presidency. The result then, for all the reasons outlined above, was the appreciation of the US dollar in real trade-weighted terms by a whopping 56 percent from 1980 to 1985. The stronger dollar and a booming economic expansion starting after 1982 led predictably to a sharp negative turn in the current account, from roughly balanced in 1980 to a deficit of 3 percent of GDP by 1985. If a Trump administration is successful in raising the rate of US economic growth against the backdrop of rising domestic interest rates, its goal of eliminating the trade deficit will be very challenging.

Although failure to reduce or eliminate the trade deficit may pose a political problem for President Trump, it shouldn’t be a problem for the US economy. Properly understood, the trade deficit is not a drag on economic growth. Imports benefit consumers and fuel the growth of import-consuming producers. A trade deficit also accommodates a net inflow of foreign capital—an “investment surplus” that creates jobs in the private sector and keeps overall interest rates lower than they would be otherwise by financing a share of the federal debt (which looks poised to keep growing under a Trump administration).

And here is where our nation’s trade and investment ties with the rest of the world could significantly affect domestic interest rates. By boosting demand for US Treasury bills, the net inflow of foreign capital year after year has kept domestic rates lower than they would have been if our trade accounts had been “balanced.”

As of September 2016, foreign investors, mostly foreign central banks, held $6.2 trillion in US Treasury securities. That’s about one-third of the US federal government’s total outstanding debt. The major investors are China and Japan, each holding about $1.1 trillion, followed by Ireland, Cayman Islands, Brazil, and Switzerland Together the latter countries hold another $1 trillion. This inflow of foreign savings prevents the federal government’s insatiable appetite for borrowing from “crowding out” private domestic investment.

By raising demand for US Treasuries, foreign purchasers exert downward pressure on our domestic interest rates. The International Monetary Fund concludes that “foreign purchases of US Treasuries are estimated to have had cumulatively reduced long term real yields by around 80 basis points.” The effect of a 0.8 percentage point rate reduction on the budget of a homeowner with a 30-year, $250,000 mortgage would be about $115 a month, or $1,380 a year. For the federal government, that figure translates into savings of $150 billion a year on interest payments on the national debt.

If policymakers in Washington somehow manage to force the closure of the US current account deficit, the result would be an offsetting decline in the net inflow of foreign savings. Along with all the damage that trade restrictions would do to the productive capacity of the US economy, a protectionist trade policy would also force interest rates and the US dollar higher, crimping the very exports, investment, and growth that those same policymakers have promised to deliver.