The unstoppable dollar wreaks havoc everywhere but America

Omnipotent dollar continues to crush everything around, causing problems for the economy almost everywhere except the United States. This means that, at least for the moment, this is not America’s problem, and the dollar’s historical rise driven by the central bank is unlikely to stop anytime soon.

Photo illustration: Justin Metz

By some measures, the US currency is already stronger than ever, having eclipsed the highs of the Covid-19 pandemic in early 2020. The pain it causes is reminiscent of the mid-1980s, when currency chaos forced the world’s most important financial officials to come together and force a solution on the markets. However, it is now every country for itself as the US administration abandons the idea of coordinated foreign exchange interventions.

With the risk of economic damage spreading, officials from Tokyo to Santiago have been forced to bail out to support their currencies through impromptu decisions such as selling dollars directly on the market. But Federal Reserve Chairman Jerome Powell is fully focused on fighting inflation at home, doubling down on interest rate hike plans that have reset the dollar rally. And US Treasury Secretary Janet Yellen said she believes financial markets are working properly.

Change in the value of currencies against the US dollar. Source: Bloomberg.

The combination of attractive US interest rates and the security of your money in dollar-denominated assets helps support the dollar. In more normal times, officials might welcome the weakening of their currencies, which tends to stimulate economic growth by making exports more competitive while encouraging consumers and businesses to buy locally. But these are not ordinary times. Right now, the problem that is troubling officials from Frankfurt to Seoul is high inflation, and weak currencies are adding fuel to the fire, driving up the cost of imported products and spurring domestic prices up. Therefore, some governments and central banks need to respond to the ongoing torture of their currencies.

The British pound has become the latest major currency to come into the spotlight after the government’s new financial plans led to a sharp decline in confidence in the pound sterling. But before that, like his peers, he was under enormous pressure, trading near multi-year lows. The yen has weakened so much that the Japanese government has entered the markets directly several times since September 22; India, Chile and other countries also found it necessary to intervene. Meanwhile, the European single currency has slipped below parity with the dollar under the weight of the energy crisis in the region, and the Chinese government has waged its own fight for the yuan.

The currency situation is also forcing central banks around the world to consider further raising their own interest rates, which could lead to a recession in their economies.

“The Fed is aware of the external implications of what they are doing because the dollar is the global reserve currency, but they have internal powers and they are focused on that,” says Paul McCulley, former chief economist at Pacific Investment Management Co., who is now teaches at Georgetown University. It’s not clear when such externalities could “turn from noise into a signal for the Fed to finally stop, turn around and affect what they’re doing,” he says. For now, McCully sees the world dancing to the Fed’s hawkish tune and suffering the “pain” that Powell himself warned about.

From the Fed’s point of view, a strong dollar does help fight inflation. By holding back the competitiveness of American business in the international arena, it holds back the growth of the economy, in turn removing some inflationary pressure. This gives officials a reason not to hold back as they implement the most aggressive monetary tightening since Paul Volcker fought runaway inflation in the 1980s. The strength of the dollar was also an issue until the so-called Plaza Accord curbed it. One key difference: The 1985 agreement between Britain, France, West Germany, Japan and the US was only struck after Volcker had already broken the back of inflation, while the outcome of the current battle is still in the balance.

“Right now, the only mandate that matters to the Fed is inflation control,” says Steven Roach, a Yale University senior fellow and former chairman of Morgan Stanley Asia. Roach said it is largely because of this sense of purpose that the world economy is heading into recession. “It will certainly change inflationary pressures — and could lead to some stabilization in the currency markets on the other hand — but in this case it puts the cart before the horse,” he says.

Case in point: Atlanta Fed President Rafael Bostic acknowledged concerns that the turmoil in the UK could spill over into the US economy as it poses risks to global growth. However, he did not abandon his support for the idea of further Fed rate hikes.

Until what is happening in the world affects the US economy, the Fed can focus on its immediate task. The key question for Powell and Yellen is whether there will come a point where international issues cannot be ignored.

The Treasury secretary said on Sept. 27 that she thought “markets are functioning well,” while White House economic adviser Brian Deese was even more outspoken that he did not expect another 1985-type deal between the major economies to counteract strengthening of the dollar. The Fed is also staying the course, raising its benchmark rate in its latest policy decision on September 21 by another 75 basis points and raising its forecasts for high borrowing costs. These moves triggered a historic meltdown in the bond markets, sending 10-year Treasury yields in excess of 4% and rising to levels last seen in 2008.

Despite the turmoil in the markets, mounting losses in bonds and equity portfolios, as well as falling currencies in other countries, are largely in line with what Fed officials are trying to devise: tighter financial terms to help curb inflation. And so far, there are few signs of sharp market failures like those seen during previous financial crises. The world’s central banks have not had to use the Fed’s emergency funds, and credit markets show that people are still more than willing to borrow and lend, albeit at a different price.

“The sell-off in US bonds and loans in the context of the Fed’s accelerated rate cycle is not disruptive,” says Alan Raskin, chief international strategist at Deutsche Bank AG. “Things can change, but we haven’t reached the tipping point yet.”

The US economy is relatively insulated from many of the shocks wreaking havoc in Europe and Asia, most notably soaring natural gas and electricity prices; even with some degree of pain inflicted by the Fed, the US remains the proverbial least dirty shirt for many investors. Of course, there will come a time when raising interest rates will really start to slow down economic growth, but how soon this will happen and by how much is unknown.

International turmoil could slow down the pace of Fed rate hikes. It is possible that conditions in major foreign economies and in global financial markets could worsen so much that this will reduce the growth prospects for the US economy. If this eases inflationary pressures in the US, it could potentially allow the Fed to put a stop to its relentless tightening of monetary policy.

Seth Carpenter, chief global economist at Morgan Stanley, notes that the Fed has reversed course in previous years due to turmoil in global financial markets, especially in early 2016 when it failed to raise rates by the percentage point promised by its officials. However, the bar could be higher this time around due to inflation and the strong labor market that is fueling it. Back in early 2016, Carpenter says, inflation was below target and job creation was much weaker.

John Connally, who ran the U.S. Treasury under President Richard Nixon some five decades ago, once told his international colleagues that “the dollar is our currency, but it’s your problem” and the U.S. is trying to deal with its inflationary bogey at seemingly any cost, it seems. , it will again become a constant headache.

According to Bloomberg

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