The writer is a professor of economics and political science at the University of California, Berkeley
The dollar has had a spectacular run, having risen more than 10 percent against other major currencies since the start of the year.
In fact, not a few governments and central banks would prefer the adjective “disastrous” to “spectacular”. For developing countries from Sri Lanka to Argentina, the rise of the greenback has made servicing dollar-denominated debts, an already difficult task, essentially impossible.
For emerging markets like Chile that are not heavily burdened with debt, inflation has increased by pushing up the local currency equivalent of dollar-denominated food and energy prices. Inflation and the fall of its currency have forced the Bank of Chile to raise its policy interest rate an extraordinary nine times last year and now to deploy its reserves to support the peso’s exchange rate.
For the European Central Bank, there has been the shame of seeing the euro fall to parity against the dollar. For the Bank of Japan, there’s the fact that the yen has been the world’s worst-performing advanced-country currency this year.
Why the dollar has strengthened is no mystery. Seeing both high inflation and strong growth, the Federal Reserve has raised interest rates faster than other major central banks, attracting capital flows to the US.
The ECB, despite cautiously starting its tightening cycle last week, is moving noticeably more slowly. The cut in Russian energy supplies is already weighing on European growth, and higher interest rates will trigger a fragile Italian debt market, given the ill-timed increase in political uncertainty in that country.
The Bank of Japan, for its part, has no immediate reason to think that the country’s “low inflation” problem has been solved, and is not inclined to abandon its “yield control” policy to maintain low interest rates. Neither the BoJ nor the ECB will match the Fed by raising policy rates in increments of 75 or 100 basis points.
Some will cite the increased geopolitical risk of the never-ending war between Russia and Ukraine and the dollar’s safe-haven status. There may be even more refuge flows with tensions around the Taiwan Strait and Iran. But at the end of the day, the latest currency movements have been driven by central banks. The same will be true in the future.
It’s no news, of course, that after falling behind the curve, the Fed is now scrambling to catch up. So the expectation of more rate hikes from Fed Chairman Jay Powell and others is already in the market. There’s no reason why these additional policy rate hikes should move the dollar higher, in other words.
But two additional events complicate the outlook for the currency market. First, other central banks, the ECB and BoJ notwithstanding, are showing an increasing willingness to match the Fed in raising rates to address their own spiraling inflation problems. These already include the central banks of Canada, the Philippines, Singapore, New Zealand and South Korea, among others. The list is growing.
The finances of these countries are strong enough to withstand rising interest rates, and inflation is a common concern. So their central banks are at least keeping pace with the Fed. As a result, the dollar has shown less strength against a broad basket that includes the currencies of these countries. The same may happen in the coming weeks and months.
Second, and more ominously, there is a risk of recession in the US. The current dollar price is based, to repeat, on the expectation that the Fed will continue to raise rates. This expectation is based, in turn, on the hopeful assumption that the US economy will continue to expand.
If the Fed’s engineered slowdown spreads from the housing market to retail sales and business investment, the combined effect will drag down not only US spending but also inflation.
The idea that, under these recessionary circumstances, inflation will remain in the high single digits, and therefore the Fed will be forced to continue its tightening cycle, is pretty silly.
As Fed chairman, Paul Volcker continued to raise rates in the face of a recession, and the dollar continued to rise, because inflation remained stubbornly high for several years. Today there is little sign of similar inflationary inertia.
So if the economy and inflation weaken, the Fed will pause and the dollar will reverse direction. This is no longer a risk that can be dismissed.