James Ferguson illustration of a superhero with the US eagle as its head, with three ghost-like figures representing the euro, pound and yen
© James Ferguson

In times of trouble, the dollar is the world’s refuge and strength. This is true even when the US is the source of the trouble, as happened in the financial crisis of 2007-09. It is true again now. A series of shocks, including high inflation in the US, has triggered a familiar upward movement in the dollar. Moreover, this has not been just against the currencies of emerging economies, but also against those of other high-income countries. Meanwhile, the general story of the dollar cycle underlies some specific ones. Messing up one’s macroeconomic policies, especially fiscal management, proves particularly dangerous when the dollar is strong, interest rates are rising and investors seek safety. Kwasi Kwarteng, please note.

Bar chart of Currency change vs US$ since Dec 31 2021 (G20 economies, %) showing Nearly all G20 currencies have fallen against the US dollar

The nominal effective exchange rate of the US dollar appreciated by 12 per cent between the end of last year and Monday, according to JPMorgan estimates. Over the same period, the yen’s effective rate depreciated by 12 per cent, the pound’s by 9 per cent and the euro’s by 3 per cent. Against the dollar alone, movements are larger: sterling has depreciated by 21 per cent, the yen by 20 per cent and the euro by 16 per cent. The dollar is king of the castle.

So why has this happened? Does it matter? What can be done about it?

As to the why, the answer is that the world economy has suffered four linked shocks since 2020: the pandemic; a huge fiscal and monetary expansion; to post-pandemic supply side, in which pent-up (and lopsided) demand hit supply constraints in industrial inputs and commodities; and, finally, Russia’s invasion of Ukraine, which hit energy, particularly for Europe.

Bar chart of Change in central bank policy rates since Dec 31 2021 (G20*, % points) showing The intervention rates of central banks have risen almost everywhere

The results have included enhanced uncertainty, strong inflationary pressure in the US, a need for monetary policy, particularly that of the Federal Reserve, to catch up, and powerful recessionary forces, especially in Europe. With the Fed’s tightening ahead of that of its peers in the high-income countries, the dollar has strengthened. Meanwhile, the divergent outcomes of emerging economies are determined by how well their economies are managed, whether they export commodities and their indebtedness.

Within the G20, surprisingly, currencies of many emerging countries have fared better than those of the high-income ones. Russia’s rouble has appreciated sharply. At the bottom are sterling, the Turkish lira and Argentine peso. What company the pound now keeps!

Does the dollar’s strength matter?

Line chart of Yield on 10-year government bonds (%) showing Yields on long-term government bonds have soared this year

Yes, it does, because, as a recent paper co-authored by Maurice Obstfeld, former chief economist of the IMF, notes, it tends to impose contractionary pressure on the world economy. The roles of US capital markets and the dollar are far bigger than the relative size of its economy suggests. Its capital markets are those of the world and its currency is the world’s safe haven. Thus, whenever financial flows change direction from or to the US, everybody is affected. One reason is that most countries care about their exchange rates, particularly when inflation is a worry: only the Bank of Japan can be happy about its weak currency. The danger is greater for those with heavy liabilities to foreigners, even more so if denominated in dollars. Sensible countries avoid this vulnerability. But many developing countries will now need help.

Chart showing the US dollar’s share in global assets and transactions

These recessionary forces emanating from the US and the rising dollar come on top of those created by the big real shocks. In Europe, above all, there is the way in which higher energy prices are simultaneously raising inflation and weakening real demand. Meanwhile, the determination of China’s leader to eliminate a virus circulating freely in the rest of the world is hitting its economy. The Chinese Communist party may control the Chinese people. But it cannot hope to control the forces of nature in this way indefinitely.

What can be done? Not that much.

There is some talk of co-ordinated currency intervention, as happened in the 1980s, with the Plaza and then Louvre accords, first to weaken the dollar and then to stabilise it. The difference is that the former, in particular, suited what the US then wanted. This made intervention credibly consistent with its domestic goals. Until the Fed is content with where inflation is going, that cannot be the case this time. Currency intervention aimed at weakening the dollar by just one or even several countries is unlikely to achieve that much.

Bar chart of OECD forecasts for CPI inflation in 2023 (%) showing Inflation forecasts are worsening across the board

A more important question is whether monetary tightening is going too far and, in particular, whether the principal central banks are ignoring the cumulative impact of their simultaneous shift towards tightening. An obvious vulnerability is in the eurozone, where domestic inflationary pressure is weak and a significant recession is probable next year. Nevertheless, as Christine Lagarde, ECB president, underlined last week: “We will not let this phase of high inflation feed into economic behaviour and create a lasting inflation problem. Our monetary policy will be set with one goal in mind: to deliver on our price stability mandate.” This may indeed turn out to be overkill. But central banks have little option: they have to do “whatever it takes” to curb inflation expectations.

Bar chart of OECD forecasts for GDP growth in 2023 (%)  showing Risks of recession are rising in high-income countries

No one knows how much tightening that might need. No one knows either how far the debt overhang will help, by acting as a powerful transmission belt, or harm, by causing a financial meltdown. What is known is that the central banks’ ability to support the markets and economy are for a while gone. In such a time the perceived sobriety of borrowers matters once again. This is true for households, businesses and, not least, governments. Even previously credible G7 governments, such as the UK’s, are learning this truth. The financial tide is going out: only now do we notice who has been swimming naked.

martin.wolf@ft.com

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