The US dollar has risen dramatically in the recent past. The value index of the US dollar against six other global currencies, compiled by the Federal Reserve Bank of Saint Louis, reached a 20-year high in late September. In October, it went sideways, without being able to predict if it reached any average peak or plateau. In any case, from January to mid-October, the dollar rose 13% against the euro, 22% against the Japanese yen and 6% against emerging market currencies.
How to explain the appreciation of the dollar
A major factor underlying the appreciation of the dollar is the higher yield in real terms of US assets relative to others. For example, the real yield differential between the US and the eurozone, as measured by five-year inflation-linked government bond yields, pairs well with the euro’s depreciation against the dollar. This differential reflected faster interest rate movements in the US, followed by the market’s conviction of the Fed’s (US central bank) anti-inflation commitment, which was stronger compared to other central banks.
Similar correlations can be found more broadly with risk-adjusted rate-of-return differentials in other fixed-income assets. Given the heights already reached by the dollar, further spurts of appreciation are likely to occur if other central banks continue to lag in setting interest rates and/or if the pace of the Fed’s adjustment accelerates further.
The place taken by liquid investments in dollars as a “safe haven”, even with low returns, also increases their demand in times of higher risk perception and lower investor appetite to carry such risks in their portfolios. In the recent period, geopolitical events and risks, such as those arising from the Russian invasion of Ukraine, have also contributed to the demand for dollars.
There were also, of course, one-off and peculiar events. Like the sharp depreciation of the pound sterling when the British government made a proposal – later withdrawn – for tax cuts without evident funding coverage. The idiosyncratic character of the European energy crisis and the very high probability of a hard recession also represented compression factors on the euro.
Implications of the appreciation of the dollar
The strong appreciation of the US dollar against other currencies in the recent past reinforced the contractionary pressures present in the global economy. On the one hand, in the US, the exchange rate appreciation acted in the direction of mitigating local inflation. However, considering the low relative weight of trade in the US GDP, nothing close to stopping domestic inflation on its own.
On the other hand, economies already facing rising domestic inflation had additionally to experience the local price increase of tradable products and, therefore, greater demand for monetary tightening. Of course, eventually, the devaluation has expansive effects on trade balances. There is however the phenomenon known as the “J-curve” effect: an initial loss before a gain follows. A country’s trade balance initially deteriorates after a devaluation of its currency, before recovering and at some point outperforming its initial performance. Supply restrictions – including energy – tended to lengthen the bottom of this “J-curve” in many cases of devaluation against the dollar. There was, therefore, a predominance of the immediate contractionary and inflationary effect.
The appreciation of the dollar also has a compressive effect on economies that have high exposure to liabilities denominated in that currency. The dollar’s rise was more intense against the currencies of other advanced economies. However, even without going through such intense devaluation, emerging and developing economies with external liabilities in dollars found themselves more vulnerable. This was the case for countries in Latin America, the Caribbean and Europe with public and private debt denominated in dollars – not for Brazil, where the government has positive net assets in dollars and there are no significant currency mismatches on private balance sheets, in addition to the country being net exporter of commodities. But it was the case of several other emerging and low-income countries dealing with external indebtedness (Sri Lanka, Zambia, Pakistan, Argentina, Turkey and many others).
It is also worth noting the negative effect on the profitability of US companies for which the income obtained abroad is significant. In addition to harming the profits of US multinationals abroad, as well as the dollar-denominated foreign liabilities of emerging markets, one way or another the appreciation of the dollar can lead to inflationary shocks in other countries and, thus, to monetary policies. even tighter. Restrictive policy feedback loops can always be triggered by a drastic and sudden appreciation of the dollar, and the rally of the dollar has evidently reminded everyone of such risks.
What to do in the face of exchange rate pressure
There is an intrinsic challenge to the globalized economy. Each central bank looks to its own country, deciding monetary policies according to what it deems necessary in relation to the local dilemma between unemployment and inflation. But in such an interdependent economy, the repercussions of any large country’s decisions go far beyond its borders. And come back. The probability of feedback from restrictive monetary policies is even greater when they all respond to a common inflationary problem.
Transmission via exchange rates is part of this interdependence. Higher interest rates in the US end up imposing on others the choice between also raising interest rates and/or allowing capital outflows and currency devaluation to occur.
Some countries are turning to direct exchange rate interventions instead of raising domestic interest rates – or as a complement. Japan opted to sell reserves of US Treasuries to try to neutralize the yen’s currency devaluation against the dollar. Switzerland also said it was considering selling foreign currency to support the Swiss franc, as well as raising interest rates between its central bank meetings.
The period after the 2008-2009 global financial crisis saw “currency wars”, when countries accused each other of exporting their unemployment problems through significant reductions in domestic interest rates and devaluation of their currencies. Could a “reverse currency war” be brewing now, as the appreciation of the US dollar exports inflation to others?
Broad coordination took place in 1985, when, as now, the dollar became overvalued. The “Plaza Agreement”, then signed between France, West Germany, the United Kingdom, Japan and the USA, had as a successful compromise the devaluation of the dollar.
However, at that time US inflation was already on the decline after a long period of high domestic interest rates, while the current tightening of monetary and financial conditions in the US is still ongoing. The most likely scenario is the absence of equivalent agreements, with some countries striving to avoid pure interest rate adjustments through direct intervention in foreign exchange markets. The effect will be limited if the underlying factors driving capital flows and exchange rate pressure do not change.
Therefore, the dollar’s “turn” or “pivot” will only occur when a “turn” or “pivot” occurs in US monetary policy. In the meantime, as recommended by Gita Gopinah and Paul-Olivier Gourrinchas, the Fed should reopen the tap on precautionary lines of credit with other central banks – as during the pandemic – to avoid the risks of these being put against the wall in situations of sudden illiquidity. in terms of dollars.
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