Last week the Prime Minister of the United Kingdom, Theresa May, called for a general election of the House of Commons in the hopes that her party would gain greater political leverage entering the final stretch of Brexit talks. In a surprising outcome, Ms. May’s party lost the majority resulting in what is known as a hung parliament. While I’m not an expert on the intricacies of British politics, I wasn’t surprised to read that the unexpected outcome had caused the British currency, the pound, to weaken.
Across the pond, the US dollar has strengthened over the past few years which sounds like a positive thing but actually, has a variety of implications. Before we get into what that means in terms of an economic outlook, it’s helpful to understand how a currency “strengthens” or “weakens.” It’s important to understand that these are relative terms. Exchange rates – how much one currency can purchase of another – are constantly moving (unless a currency is pegged to another). At this time last year, £1 would buy you $1.42. As of this writing, £1 would buy you $1.27. This is where we get the term “weaker” from. British pounds cannot purchase as many US dollars currently as they could have a year ago, thus the pound has "weakened." Conversely, at this time last year, $1 would buy you £.7o and now $1 will buy you £.78. The dollar has strengthened because US dollars will now buy more British pounds than they did a year ago.
So what are the implications of stronger and weaker currencies? Initially, you would think that a stronger currency is better (stronger is better than weaker right), but it’s not that simple. As owners of US dollars we can now buy more foreign goods than we could have before which is pretty great (just think of how many things you buy that are made in China). Unfortunately, it also means our goods are more expensive for others which may make them want to do business with other, cheaper currencies. This lowers our exports which can cause our economy to grow at a slower pace. At the same time, foreign goods become cheaper which typically causes us to import more resulting in a trade deficit (a negative balance of trade in which we import more than we export).
Over the last ten years, our trade deficit has fallen as we’ve become less dependent on importing oil and have increased the services we export to other nations. If the dollar continues to strengthen we’ll want to be wary of maintaining our balance of trade and staying competitive in the global marketplace. At the same time, we also want domestic companies to be competitive at home and their products to remain affordable for our consumers relative to foreign products. A strong dollar is generally a positive thing when it is accompanied by a strong economy but less of a boon when the cause is not a strong domestic economy but simply other currencies weakening against it. We have a little bit of both going on right now which is why many economists and financial analysts are keeping a wary eye on the dollar as the market continues its run. If you’d like to learn more about how exchange rates and the trade deficit affect the economy, check out this article in Forbes by a former Fed president, or this article that has a simple explanation of the balance of trade.
“British Pound Per US Dollar Graph.” X-Rates.com. 2017. http://www.x-rates.com/graph/?from=USD&to=GBP&amount=1.
“US Dollar Per 1 British Pound Graph.” X-Rates.com. 2017. http://www.x-rates.com/graph/?from=GBP&to=USD&amount=1.