Currency Act Impact
Barton Ostby
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The value of a currency is an important determinant for prices in international trade. When the value of a currency changes, prices for goods traded using that currency can be affected. A currency appreciation (when the value increases over time) results in a lower effective price for imported goods; currency depreciation (when the value decreases over time) translates to higher import prices. By and large, firms across the world have adopted the relatively stable U.S. dollar as their preferred currency for import and export transactions. But shifts in U.S. dollar exchange rates with many other currencies shook up international trade prices in 2022. This Beyond the Numbers article will discuss how interest rate increases affect the value of the U.S. dollar and the consequences on import and export prices and consumers. The article will also examine certain world currencies, the housing market, and commodities.
You may be wondering, what is the upshot? Broadly, a currency appreciation in the United States means that one dollar can now buy more of a good valued in a foreign currency. Accordingly, as the dollar strengthened, import consumer goods prices fell. Consumer goods prices declined 0.5 percent from April to June 2022 when the dollar started to rise, then rebounded slightly with a 0.3-percent rise from June to August 2022 when the dollar briefly leveled. Prices for consumer goods then declined, falling 0.4 percent from August to December 2022 as the dollar strengthened and subsequently weakened, even as the FOMC continued increasing interest rates.
Capital goods prices were also influenced by the appreciating dollar, though more mildly than consumer goods prices.4 The impact was slower to unfold, as long-term contracts are more prevalent with capital goods purchases. Import capital goods prices remained unchanged by the stronger dollar until May 2022, then advanced a mere 0.5 percent from May to December 2022 as supply chain constraints continued to hinder production capabilities in the sector.
Though the effect is indirect, rising U.S. interest rates and the subsequent increase to both consumer and manufacturing costs can impact the demand for petroleum products as well. If the overall cost of living increases, consumers may elect to forgo travel and other cost-prohibitive activities as affordability drops even further. Likewise, rising interest rates could impact the amount of petroleum demanded by manufacturers, because the cost of producing and transporting goods will be higher.
Furthermore, oil exporters often price their product in U.S. dollars, which means a stronger dollar can make oil effectively more costly for importers using a different currency, resulting in a demand decrease. Prices for U.S. import petroleum fell 37.3 percent from June to December 2022.
Interest rate hikes also dampened activity in the U.S. housing market. Rising mortgage rates in 2022 increased the cost of borrowing money, which in turn reduced demand for loans from potential home buyers. At the same time, U.S. homebuilding declined, falling 8.8 percent for the year ended October 2022.5 Single-family housing starts, accounting for the largest share of homebuilding, decreased to the lowest level since May 2020. From a recent peak in March 2022 to the end-of-year data from December 2022, prices for selected building materials imports decreased 21.4 percent.
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4 Capital goods and consumer goods are end-use classifications that identify goods based on principal end-use rather than the physical characteristics of the merchandise. For more information, see -reach/2012/03/end-use-trade-term-of-the-month-2.html.
In the global financial marketplace, a company can maintain its books in one currency, answer to the interests of stockholders whose equity securities are valued in a second currency, issue bonds denominated in 2 or more other currencies, and maintain material business operations in currencies other than any of the preceding.
To see the complexity, consider Nestl S.A. as a prototype. It is headquartered in Switzerland, so the base currency of its group financial statements is the Swiss franc. However, according to company reports, its entire European zone of operations accounted for only about one-quarter of its total revenue, while a little less than one-third came from Asia, Africa, and the countries of the Pacific Rim, and just about half came from North and South America.
Moreover, as maker of many well-known consumer products in the United States, the company attracts a significant following among US investors, so it sponsors an ADR (American depositary receipt) program for trading its shares in the United States. That compels Nestl to create parallel financial reports translated from Swiss francs into US dollars. And for bond investors, Nestl has issued significant amounts of debt traded around the world. Various portions of this debt are denominated in Swiss francs, euros, US dollars, Australian dollars, and Norwegian krone.
A globally diverse company typically conducts material volumes of routine business in dozens of currencies throughout the year. As a result, its business operations and balance sheet may be subject to significant currency market effects, and these could have strong influences on performance.
For example, from 1971 to 2022, the daily average year-on-year change in the value of the US dollar relative to the Canadian dollar was a small fraction of 1%. But there were one-year periods where there were substantial swings up and down. Moreover, the standard deviation of the values is many times the average value. Standard deviation measures the amount of dispersion seen among the individual one-year results. A relatively large standard deviation implies that the chance of randomly finding average or near-average results in any particular one-year period is relatively small. For information on currency and exchange rates, see the Federal Reserve's Foreign Exchange Rates pages.
Assets and liabilities on the balance sheet that are not denominated in the home currency are typically translated into home-currency values using a specified exchange rate. Asset purchases and sales not denominated in the home currency are typically translated at the exchange rates prevailing at the time of the transaction.
Year-to-year changes in foreign currency-based balance sheet values reflect both changes in the underlying asset/liability and changes in the exchange rate used for the translation. Gains or losses attributable to currency moves may be disclosed separately. If not, you can estimate underlying changes by translating each value in a time series back into its local currency using prevailing exchange rates for its period. You can find up-to-date currency and exchange rates information on the Federal Reserve's website.
International operations are generally conducted in local currencies, with net operating results consolidated into the base currency periodically. As with assets and liabilities, the translated net operating results may reflect both operationally based and exchange rate-based changes.
Major foreign companies that list their shares in the United States through ADRs generally translate their foreign currency statements into US dollars using an exchange rate prevailing at the time of the statement. A US investor evaluating currency effects would have to first consider the translation effects into the base currency of the foreign company, and then the added effects of translation from that base currency into US dollars.
Investments in bonds denominated in foreign currencies pose complex accounting and performance issues for their holders. For a US investor, the effective interest payments and principal values from a foreign currency-denominated bond can be reduced if that currency weakens against the US dollar. That would lower the value of future interest payments and redemption amounts when translated back into dollars. Conversely, the net US dollar returns from any particular foreign bond could be enhanced if that bond's base currency strengthens.
As noted, currency changes over time are commonly significant, so their effects on global investment performance can be material. Understanding how those changes might impact your investment scenarios is a first step toward understanding your exposure to global currency risk and to effective strategies for diversifying it.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Financial currency risks result from the translation of receivables, liabilities and other monetary items in accordance with IAS 21 at the closing rate into the functional currency of the respective Group company. In addition, we incorporate planned purchase and sales transactions in foreign currencies into our financial foreign currency risk management. If necessary, we hedge these risks using derivative instruments.
According to our analysis, this strong performance is related to improvements in the credibility of central banks since the late 1990s. Stronger and more independent central banks in the region have been able to better anchor inflation expectations, thus preventing increases in the price of non-tradable goods following depreciations. This largely explains why the inflationary impacts of the recent episodes have been so modest despite the extent of currency depreciations in countries with well-established inflation targeting regimes, such as Chile, Colombia, Mexico, and Peru.
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