Alternate name: Nominal Broad-Dollar Index, Broad Index
The Federal Reserve’s weightings show the importance of various countries to U.S. trade. The most predominant countries involved in U.S. trade are China, Mexico, and Canada. That ranking is reflected in these top trade weightings (as of Jan. 3, 2022): 14.763 for China, 13.248 for Mexico, and 12.988 for Canada. This weighting relative to U.S. trade is very different from the weightings based on share of the global economy. For example, Japan is the world’s third-largest economy behind China and the U.S., but it has a 5.953 weight in the Trade-Weighted Dollar Index.
How the Trade-Weighted US Dollar Index Works
Trade-weighted indexes can be calculated for any currency. In the U.S., the Federal Reserve Bank weights world currencies based on their importance to U.S. import and export activity. The index itself is calculated as the weighted sum of the exchange-rate logarithms, then is charted to show the equivalent percentage changes in the index relative to the last trading day. If the index has a positive move, that means that the currency being measured has strengthened against its partner currencies, which is usually good for import activity. A negative move indicates that the currency has weakened against its partner currencies, which is usually good for exports. Each country or economic group can calculate its own version of the index. For example:
Canada’s trade-weighted index has a 0.79 weighting for the U.S., which is its largest trade partner. The International Monetary Fund (IMF) has a global trade-weighted index that it uses to calculate REER, for real effective exchange rate. The European Union’s trade-weighted effective exchange rate index has been adjusted several times to reflect changes in the makeup of the EU’s members and of its currencies. The Bank of England’s trade-weighted index is adjusted regularly to reflect changes in the nation’s trade pattern. The Federal Reserve Bank of Dallas takes the Trade-Weighted U.S. Dollar Index a step further and looks at how it varies from state to state, given that different states have different export industries and import demands.
What It Means for Individual Investors
The Trade-Weighted U.S. Dollar Index is useful for thinking through the effects of exchange rates on the economy. We talk about currency exchange rates being “weak” or “strong,” but those are relative terms. They don’t equate with “bad” or “good.” Someone with foreign currency can buy more if the dollar is weak, which is good for companies that export. If the dollar is strong, then Americans can buy more imported goods for their money. The exchange rate measures the relative strength or weakness of two different currencies. The dollar trade-weighted index shows how the U.S. dollar is doing against its trading partners. For example, if the U.S. dollar appreciates against the Mexican peso, it’s probably due to Mexico’s policies, not U.S. policies. If the Trade-Weighted U.S. Dollar Index increases, then the dollar is strengthening against the currencies of a basket of its main trading partners, and that’s probably due to changes in U.S. policies. The dollar’s strength against the peso is good for companies that import from Mexico. The dollar’s strength against all its trading partners creates a more complex situation, with both pros and cons.
