In times of difficulty, the dollar is the refuge and the strength of the world. This is true even when the US is the source of the problems, as happened during the 2007-09 financial crisis. It is now true again. A series of shocks, including high inflation in the US, have led to a well-known upward movement in the dollar. Moreover, this was not only against the currencies of emerging economies, but also against those of other high-income countries. Meanwhile, the general story of the dollar cycle underlies some specific ones. Messing up macroeconomic policies, especially fiscal management, proves particularly dangerous when the dollar is strong, interest rates are rising and investors seek safety. Kwasi Quarteng, pay attention.
According to estimates by JPMorgan, the nominal effective exchange rate of the US dollar has risen 12 percent between the end of last year and Monday. During the same period, the effective rate of the yen fell by 12 percent, the pound by 9 percent and the euro by 3 percent. Against the dollar alone, the movements are larger: the pound sterling has depreciated by 21 percent, the yen by 20 percent and the euro by 16 percent. The dollar is the king of the castle.
So why did this happen? Does it matter? What can be done about it?
As for why, the answer is that the global economy has been dealing with four coupled shocks since 2020: the pandemic; a massive fiscal and monetary expansion; on the post-pandemic supply side, where pent-up (and one-sided) demand hits supply constraints in industrial inputs and raw materials; and, finally, the Russian invasion of Ukraine, which struck energy, especially for Europe.
The results included heightened uncertainty, strong inflationary pressures in the US, the need for monetary policy, especially that of the Federal Reserve, to catch up, and strong recessionary forces, especially in Europe. With the Fed tightening ahead of its peers in the high-income countries, the dollar has strengthened. Meanwhile, the varying results of emerging economies are determined by how well their economies are managed, whether they export commodities and their debt load.
Within the G20, the currencies of many emerging countries have surprisingly outperformed those of the high-income countries. The Russian ruble has appreciated strongly. At the bottom are the pound sterling, the Turkish lira and the Argentine peso. What company does the pound keep now!
Does the strength of the dollar matter?
Yes, it does because, as a recent article co-authored by Maurice Obstfeld, former chief economist at the IMF, points out, it tends to put contractive pressures on the global economy. The role of the US capital markets and the dollar is much greater than the relative size of the economy would suggest. Its capital markets are the world’s and its currency is the world’s safe haven. So when financial flows to or from the US change, everyone is affected. One reason is that most countries care about their exchange rates, especially if inflation is a concern: only the Bank of Japan can be happy with its weak currency. The danger is greater for those with heavy obligations to foreigners, especially if they are denominated in dollars. Wise countries avoid this vulnerability. But many developing countries will now need help.
These recessionary forces coming from the US and the rising dollar are in addition to those caused by the big real shocks. In Europe, there is mainly the way in which higher energy prices simultaneously increase inflation and weaken real demand. Meanwhile, the Chinese leader’s determination to eradicate a virus circulating freely in the rest of the world is affecting his economy. The Chinese Communist Party can control the Chinese people. But it cannot hope to control the forces of nature in this way indefinitely.
What can be done? Not so much.
There is coordinated currency intervention, as happened in the 1980s with the Plaza and then the Louvre agrees, first to weaken the dollar and then to stabilize it. The difference is that the first in particular suited what the US wanted at the time. This made the intervention credible in line with domestic targets. Until the Fed is happy with where inflation is heading, it may not be this time. Currency intervention aimed at weakening the dollar with just one or even several countries is unlikely to achieve that much.
A more important question is whether monetary tightening is going too far and in particular whether major central banks are ignoring the cumulative impact of their concomitant shift to tightening. A clear vulnerability lies in the eurozone, where domestic inflationary pressures are weak and a significant recession is likely next year. Nevertheless, as ECB president Christine Lagarde underlined last week: “We will not allow this phase of high inflation to spill over into economic behavior and create a lasting inflation problem. Our monetary policy will be set with one goal in mind: to fulfill our mandate for price stability.” Indeed, this may turn out to be overkill. But central banks have little choice: they must do everything they can to curb inflation expectations.
No one knows how much tightening that needs. No one also knows how much debt overhang will help by acting as a powerful transmission belt, or harm by causing financial collapse. What is known is that the central banks’ ability to support the markets and the economy will be gone for a while. At such a time, the perceived sobriety of borrowers is important again. This applies to households, companies and, last but not least, governments. Even previously credible G7 governments, such as that of the UK, are learning this truth. The financial tide is fading: only now do we notice who swam naked.
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