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Foreign Exchange for Expats in the United States Of America

Submitted: July 2013

The national currency is the US dollar (USD). The Federal Reserve System (Fed) has been the US central banking system since enactment of the Federal Reserve Act in 1913. Accordingly, the Fed is responsible for US monetary policy.

Exchange rate regime

The US dollar is a freely floating currency. However, many countries have decided to peg their national currencies to the US dollar.  These countries are typically in Middle East or the Caribbean.

Monetary policy

The Fed has a mandate to promote maximum employment, price stability, as well as moderate long-term interest rates.

Inflation-targeting is part of US monetary policy. There is no official inflation target, but a case can be made that the Fed would rather anchor inflation below 2%. However, inflation-targeting is subject to constant debate and the opinion of US central bankers may evolve over time.

When the Fed decides to tighten monetary policy (e.g. when inflation is too high), liquidity dries up, market interest rates rise and inflation may go down. If the Fed wishes to loosen monetary policy (e.g. when GDP growth isn’t strong enough), markets are subject to higher liquidity and lower interest rates, but this may create inflationary pressures.

Higher interest rates, whether expected or actual, tend to drive down securities prices. See Investment for Expats in the US.

Current trends

Since the 2008 financial crisis, the Fed has held interest rates at record lows (between 0 and 0.25%). In addition, it has embarked on an unprecedented Quantitative Easing (QE) programme, whereby the Fed intervenes on the open market to purchase mortgage-backed securities and Government debt. This is basically money printing to avoid deflation and depression.

At the moment, the Fed adds $85bn per month to its balance sheet. However, the market largely anticipates the Fed to gradually unwind the QE programme as early as in late 2013.

As QE has forced market interest rates lower (e.g. on US Government debt), any QE withdrawal might push them higher, thereby shrinking securities prices. Don’t overestimate this effect though, as:

  1. The market has already had the time to price in some QE withdrawal, and
  2. The Fed is unlikely to phase out QE unless the US economy shows some resilience. In that case, this means good prospects for corporate earnings, and this should add further upward pressure on share prices.

When the US sneezes, the world catches a cold

The Fed has so much firepower that any US monetary policy shift may have significant repercussions on foreign financial markets. Developing countries are the most vulnerable to these US monetary policy shifts.

Demand for emerging currencies rises strongly when US monetary policy loosens. However, the same emerging countries are subject to very large capital outflows when the US tightens monetary policy. This aspect has played a critical role in the East Asian crisis during the mid-1990s.

In spring 2013, the Fed has indicated that it would gradually “taper” its QE programme. No US monetary tightening has actually been made so far, but the simple announcement has coincided with large risky asset selloffs. Throughout summer 2013, many emerging currencies (e.g. Brazilian real, Indian rupee, Turkish Lira) have come under intense bearish pressure as markets expect the US to tighten monetary policy.

 

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