The Dollar Dazzles Once More

The dollar is sky-high.  Since May 2021, it has risen 19% against Europe’s euro, even reaching 1-to-1 parity in recent weeks. The dollar has appreciated 20% against Britain’s pound.  And it is up 28% against Japan’s yen, provoking the Bank of Japan to sell dollars on September 22, essentially the first foreign exchange intervention by a G-7 country since 2011 and the first in the direction of supporting a currency’s value against the dollar since the euro in 2000.

On the basis of a weighted-average among major trading partners, the dollar is the highest it has been in twenty years.  When judged against a broad set of foreign currencies, the US currency is now even stronger than it was in 2002.  One has to go back to 1983-85 to find an episode when the dollar was clearly higher than it is today.

It may seem surprising that the dollar is so strong currently, during a period of high US inflation and slowing growth, both of which have received a huge amount of attention and both of which, in themselves, should have negative effects on the demand for dollars.  So, does the current exchange rate belong on the ever-lengthening list of recent developments that seem inexplicable or unprecedented?  No.  The dollar’s strength can be explained by economic fundamentals.

1. The effect of growth rates

It is true that the US economy has slowed markedly this year, relative to the rapid 5 ½ % growth rate during 2021, and that many are calling this a recession.  But it is the differential in growth rates that matters for determination of the exchange rate.  And other countries are more likely entering recessions now than is the US.

The US economy remains relatively vigorous, so far, when judged by the labor market and other important indicators.  Meanwhile, the United Kingdom and continental Europe are in the throes of an energy crisis, due to the loss of Russian natural gas.  Growth in China has almost vanished, suffering from the effects of a bursting housing bubble and continued futile pursuit of a zero-Covid policy. Japan’s anemic growth rate has yet to restore its GDP to where it was in the years preceding the 2020 recession.

2. The effect of high commodity prices

The US inflation of 2021 turned out not to be transitory.  And inflation makes people very unhappy.  But it has risen almost everywhere.

One circumstance in which inflation has a negative effect on a country’s real income and the real value of its currency is when the prices of the goods that the country imports and consumes rise relative to the prices of the goods that it produces and exports.  Such an adverse shift in the “terms of trade,” reminiscent of the supply shocks of the 1970s, describes the current situation among countries in Europe and East Asia that are dependent on imports of fossil fuels, minerals, and agricultural commodities. But the US has always been a net exporter of farm products, and in recent years has again become a net exporter of energy (thanks in part to fracking).  So, the US has not suffered the same adverse shift in the terms of trade that others have.  Greater sensitivity to the recent commodity shocks among trading partners is one factor explaining the depreciation of their currencies against the dollar.

3. The effect of rising interest rates

Unlike countries suffering from an adverse shift in their terms of trade, the US can offset the costs of inflation by tightening monetary policy — which is precisely what the Fed has been doing all year.  That includes the 75-basis point increase in the short-term interest rate announced by the Federal Open Market Committee on September 21, with a promise of more to come.

The differential in monetary policies between the US and other major countries is probably the main force acting on the dollar The Fed is raising interest rates faster than the European Central Bank is.  Meanwhile the Bank of Japan has yet to move away from its super-easy monetary policy and even continues to hold down longer-term rates.  The widening of the interest rate differential makes dollar assets more attractive to global investors and hence works to appreciate the currency.

Furthermore, the dollar retains its status as a safe haven, a destination for nervous capital whenever global risk spikes.  It remains the leading international currency.  The euro, yen, pound and yuan trail well behind, by such measures as the currency composition of foreign exchange reserves or the volume of foreign exchange trading.

4. Effects of dollar appreciation

So much for the causes of a high dollar.  What are the effects?

It comes with pros and cons.  From the viewpoint of the US, the pro is downward pressure on inflation, while the con is a loss of competitiveness in international trade.  From the viewpoint of other advanced countries, the pro is a gain in international competitiveness and the con is an exacerbation of inflation, particularly in the form of the higher commodity prices they face.

Meanwhile many developing countries (even the commodity exporters, which benefit from higher global commodity prices), have to contend with the problem of currency mis-match: if they have dollar-denominated debts, the increase in the cost of dollars in terms of their own currencies raises debt service requirements in terms of their own currencies.

The US is likely to face rising complaints about dollar appreciation, a sign of  “reverse currency wars,” and to hear calls for cooperation among central banks to limit the increase in interest rates.  There may even be proposals for a new Plaza Accord, an effort to intervene in the foreign exchange market to bring the dollar back down to earth, as happened in 1985.  But the current episode of dollar appreciation is rooted in economic fundamentals: economic strength in the US relative to trading partners and (consequently) interest rates that are rising in the US faster than abroad.  So long as that remains true, a strong dollar makes sense.