Opinion – Martin Wolf: Why Dollar Strength Matters

In times of trouble, the dollar is the refuge and strength of the world. This is true even when the United States is the source of the problem, as was the case in the 2007-09 financial crisis. It’s true again now. A series of shocks, including high inflation in the US, triggered a well-known bullish move in the dollar. Furthermore, this was not only against the currencies of emerging economies, but also against those of other high-income countries. However, the general story of the dollar cycle underlies some specific ones. Disrupting macroeconomic policies themselves, especially fiscal management, is particularly dangerous when the dollar is strong, interest rates are rising and investors are looking for safety. Kwasi Kwarteng, please take note.

JPMorgan’s estimate for the nominal effective exchange rate of the US dollar appreciated 12% between the end of last year and last Monday (26). In the same period, the yen’s effective rate depreciated by 12%, the pound 9% and the euro 3%. Only against the dollar the movements are greater: the pound sterling depreciated 21%, the yen 20% and the euro 16%. The dollar is the king of the castle.

So why did this happen? This matters? What can be done about it?

As to why, the answer is that the world economy has suffered four linked shocks since 2020: the pandemic; a huge fiscal and monetary expansion; on the post-pandemic supply side, where pent-up (and uneven) demand has hit supply constraints on industrial inputs and commodities; and, finally, Russia’s invasion of Ukraine, which hit energy mainly to Europe.

The results included heightened uncertainty, strong inflationary pressure in the US, the need for monetary policy, particularly from the Federal Reserve, to catch up, and powerful recessionary forces, especially in Europe. With the Fed crunching ahead of its peers in high-income countries, the dollar has strengthened. Meanwhile, the divergent results of emerging economies are determined by how their economies are managed, whether they export commodities and their debt.

Within the G20, surprisingly, the currencies of many emerging countries fared better than those of high-income countries. The Russian ruble has appreciated sharply. At the bottom are the pound sterling, the Turkish lira and the Argentine peso. The pound is now in good company!

Does dollar strength matter?

Yes, because, as a recent article co-authored by Maurice Obstfeld, former IMF chief economist, notes, it tends to impose contractionary pressure on the world economy. The roles of US capital markets and the dollar are much larger than the relative size of their economy would suggest. Its capital markets are those of the world and its currency is the safe haven of the world. So whenever financial flows change direction to or from the US, everyone is affected. One reason is that most countries care about their exchange rates, particularly when inflation is a concern: only the Bank of Japan can be happy with its weak currency. The danger is greater for those who have heavy debts with foreigners, even more so if denominated in dollars. Sensible countries avoid this vulnerability. But many developing countries will now need help.

These recessionary forces emanating from the US and the rising dollar add to those created by the big real shocks. In Europe, in particular, there is the way that higher energy prices are simultaneously driving up inflation and weakening real demand. Meanwhile, the determination of China’s leader to eliminate a virus that circulates freely in the rest of the world is taking a toll on his economy. The Chinese Communist Party can control the Chinese population. But you cannot expect to control the forces of nature in this way indefinitely.

What can be done? Not a lot.

There is talk of a coordinated monetary intervention, as happened in the 1980s, with the Plaza and then the Louvre agreements, first to weaken the dollar and then to stabilize it. The difference is that the former, in particular, suited what the US wanted. This made the intervention consistent with its domestic goals. Until the Fed is satisfied with the direction of inflation, that cannot be the case this time around. A currency intervention aimed at weakening the dollar in 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 simultaneous shift towards tightening. An obvious vulnerability lies in the eurozone, where domestic inflationary pressure is weak and a significant recession is likely in the next year. However, as Christine Lagarde, President of the European Central Bank, pointed out last week: “We will not let this phase of high inflation influence economic behavior and create a problem of lasting inflation. Our monetary policy will be defined with a goal in mind. : fulfilling our mission of stabilizing prices”. This can really become excessive. But central banks have few options: they have to do “whatever it takes” to contain inflation expectations.

Nobody knows how much tightening this might require. No one knows to what extent the outstanding debt will help, acting as a powerful transmission belt, or harm, causing a financial meltdown. What is known is that the ability of central banks to support markets and the economy is long gone. At such a time, the perceived sobriety of borrowers matters once again. This is true for families, businesses and, not least, governments. Even once-trusted G7 governments like the UK are learning this truth. The financial tide is going out: only now do we realize who was swimming naked.

Translated by Luiz Roberto M. Gonçalves