Jhe US dollar collapsed this summer. The Japanese yen and the euro fell to their lowest levels against the greenback in two decades; the euro, which had long been worth more than a dollar, is now approaching parity. The U.S. Federal Reserve’s trade-weighted broad dollar index has nearly recovered to the high it hit in March 2020 amid the panic triggered by the onset of the Covid-19 pandemic. In fact, if inflation in the United States and its trading partners is taken into account, it is already higher.
This comes despite the United States recording its highest annual inflation rate in four decades and its worst trade balance since the global financial crisis. What is happening and will the dollar fall?
While acknowledging that exchange rates are extremely difficult to explain, let alone predict, four important factors seem to influence the movements of the world’s major currencies. More importantly, the Fed has started raising interest rates, and with the US economy seemingly far from a true recession, there is still room for it to tighten policy further.
Despite equally high inflation in Europe, the European Central Bank is more cautious. This is partly because the economic outlook for the euro zone is more fragile. The ECB is concerned about Italy’s high level of debt, but also believes that current rates of energy price inflation will not continue. Japan, like China, has so far not experienced significant inflation. The Bank of Japan is unlikely to tighten policy anytime soon and the People’s Bank of China cut rates in August.
Geopolitics is also a factor explaining the strength of the dollar. The war in Ukraine poses a much more immediate risk to Europe than to the United States, while China’s ominous saber slashes against Taiwan pose a huge risk to everyone, but especially to neighboring Japan. Recession or not, Europe and Japan will have to significantly restructure their defense capabilities, with a concomitant increase in long-term military spending.
Then there is the ongoing economic slowdown in China, which affects Europe and Japan far more than America. The root causes of China’s growth deceleration — including zero-Covid lockdowns, the legacy of overbuilding, repression of the tech sector, and excessive centralization of economic power — are issues I’ve been commenting on for some time, and I do not see a clear solution, a sustained recovery.
Finally, with energy prices still very high, the fact that the United States is self-sufficient in energy while Europe and Japan are major importers also benefits the dollar.
Some would add that the United States is a safer haven than Europe and Japan. That may be true, even if America is mired in a cold civil war that cannot end as long as Donald Trump is on board. Eurozone integration, which promises to advance in a crisis, will be put to the test if global real interest rates ever begin to rise. Inflation in Germany is on track to hit a 70-year high, but more aggressive interest rate hikes from the ECB could send Italian government debt spreads skyrocketing.
The current strength of the dollar has profound implications for the global economy. Much of world trade, perhaps half, is denominated in dollars – and for many countries this applies to both imports and exports. Thus, a rise in the dollar causes much of the world to reduce its imports, so much so that the researchers found a statistically significant negative impact on world trade.
A strong greenback is likely to have a particularly harsh effect on emerging markets and developing economies, as private companies and banks in those countries that borrow from foreign investors can only do so in dollars. And higher US interest rates tend to disproportionately raise interest rates for weaker borrowers. In fact, the broad dollar index would have risen even more if many emerging market central banks had not proactively raised interest rates to stem the downward pressures on national currencies. But such a tightening of course weighs on their national economies.
The fact that major emerging markets have so far largely resisted higher US interest rates and the appreciation of the dollar has been a pleasant surprise. But how long they will continue to do so if the Fed pursues an aggressive tightening path remains to be seen, particularly if commodity prices fall simultaneously (as my Harvard colleague Jeffrey Frankel has warned) and states United and Europe are sinking into recession, in addition. of the slowdown in China.
In the short term, a strong dollar will affect America less severely than its trading partners, primarily because US trade is almost entirely priced in dollars. But an ever-stronger dollar will have a longer-term national impact, as the United States becomes a relatively more expensive place to produce. This will not help foreign tourism, still down sharply from 2019.
Could the recent surge in the dollar against other major currencies be reversed? To be sure, some previous sharp rises in the value of the dollar, notably in the mid-1980s and early 2000s, were eventually followed by sharp declines. But, again, exchange rates are notoriously difficult to predict, even over a one-year horizon. A further 15% drop in the euro and yen against the US currency is entirely possible, especially if geopolitical friction escalates again. The only thing that can be said with certainty is that the period of extraordinarily calm exchange rates of major currencies, which began in 2014, is now a thing of the past.
Kenneth Rogoff is a professor of economics and public policy at Harvard University and was chief economist of the International Monetary Fund from 2001 to 2003.
© Syndicate Project