How does the Federal Reserve influence the USD exchange rate?

Federal ReserveMonetary Policyexchange rateUSDInterest Rate
Views: 0Created At: 9/4/2025Updated At: 9/17/2025
婷婷 张
婷婷 张

Okay, this question isn't actually that complicated. Let me explain it to you in plain language.

You can think of the US dollar as a commodity, and the Federal Reserve (the Fed) is like the sole major dealer for this commodity. This dealer has several powerful tools it can use to control the price of this commodity in the market (which is its exchange rate).

1. The Most Crucial Tool: Interest Rates (Raising and Lowering Rates)

This is the Fed's most frequently used and most potent weapon.

You can imagine "holding US dollars" as doing a dollar investment with a bank. If interest rates are high, your investment returns are high; if they're low, your returns are low.

  • When the Fed raises interest rates:

    1. The "investment returns" on the dollar become higher, making it particularly attractive.
    2. Hot money (international investors) from around the world think, "Wow, I can earn more money by depositing dollars or buying US Treasury bonds!"
    3. As a result, everyone rushes to sell their other currencies (like euros, yen, or yuan) to exchange them for dollars, then buy these high-yield dollar assets.
    4. With more people eager to buy dollars in the market, based on supply and demand, the dollar naturally appreciates (its exchange rate rises).

  • When the Fed lowers interest rates:

    1. The "investment returns" on the dollar become lower, reducing its appeal.
    2. Investors feel that keeping money in the US isn't cost-effective and would rather convert it to other countries' currencies to invest in places with higher returns.
    3. As a result, everyone starts selling dollars and buying other currencies.
    4. With more people selling dollars in the market, the dollar depreciates (its exchange rate falls).

In a nutshell: Rate hikes make the dollar more "appealing," attracting capital inflows and strengthening the dollar; rate cuts make the dollar less "appealing," leading to capital outflows and weakening the dollar.

2. The "Money Printer" Switch: Quantitative Easing (QE) and Quantitative Tightening (QT)

This sounds high-level, but it's actually quite easy to understand.

  • Quantitative Easing (QE):

    • You can simply understand this as the Fed "starting the money printer."
    • The Fed injects a large amount of new dollar liquidity into the market by directly purchasing government bonds and other assets.
    • Imagine that the quantity of dollars in the market suddenly increases. According to the principle of "scarcity makes things valuable," the dollar itself becomes less valuable.
    • Therefore, QE usually leads to dollar depreciation.

  • Quantitative Tightening (QT):

    • This is the exact opposite and can be understood as the Fed "withdrawing dollars from the market."
    • It stops purchasing new government bonds and allows previously purchased bonds to mature, taking the cash out of the market rather than reinvesting it.
    • As a result, the quantity of dollars in the market decreases.
    • With fewer dollars, they naturally become more "expensive."
    • Therefore, QT usually leads to dollar appreciation.

In a nutshell: QE is like scattering money, so there's more of it and it's less valuable, leading to dollar depreciation; QT is like pulling money back, so there's less of it and it's more precious, leading to dollar appreciation.

3. The Power of "Jawboning": Managing Market Expectations

This tactic is also crucial. Sometimes, the Fed doesn't even have to act; its words alone can influence the market.

  • Statements by the Fed Chair, various officials, press conferences, meeting minutes, and so on, all send signals to the market.
  • For example, if the Fed Chair says, "We believe there's significant inflationary pressure ahead, and we might need to consider raising interest rates."
  • Smart people in the market immediately understand: "Oh, the dollar is likely to strengthen in the future!" They will act in advance, starting to buy dollars now.
  • The result is that even before the Fed actually raises rates, the dollar's exchange rate might have already gone up. This is called "expectations being priced in."

In a nutshell: The Fed guides people's thoughts by "floating trial balloons," and people hear the signals and act pre-emptively, thereby influencing the exchange rate.

A Simple Analogy:

You can think of the Fed as a reservoir manager, and the dollar is the water in the reservoir.

  • Raising interest rates = Telling everyone, "The water in my reservoir is sweet and highly nutritious!" This attracts people from outside to come and buy the water.
  • Lowering interest rates = Telling everyone, "The water in my reservoir tastes ordinary," so people go and buy water from other sources.
  • Quantitative Easing (QE) = Opening the floodgates and releasing water. When there's more water, it naturally becomes less valuable.
  • Quantitative Tightening (QT) = Closing the floodgates and pumping water back from outside. When there's less water, it becomes more precious.
  • Officials' statements = Shouting through a loudspeaker, "I'm going to open the floodgates tomorrow!" or "I'm going to make the water sweeter next month!" People hear the broadcast and prepare in advance.

I hope this explanation makes it clear for you!

Created At: 09-04 09:50:48Updated At: 09-04 09:55:15