The strength of the greenback is proof that the Fed’s anti-inflationary campaign is starting to gain traction, even as prices continue to climb overall. But it’s a different story overseas, where currency weakness in Europe and the UK – the flip side of the strong dollar – is making the fight against inflation even more difficult.
As years of low inflation and low interest rates have given way to a more volatile era, currencies are trading in a wider arc. In particular, the war in Ukraine, which has disrupted world food and fuel markets, has dealt harder blows to Europe and many developing countries than to the United States, which explains the current shine of the dollar.
“The dollar, euro, yen and yuan have been in relatively small ranges for a very long time. This is the first time in decades that everyone is down against the dollar,” said Adam Posen , President of the Peterson Institute for International Economics.
The stronger dollar is straining the budgets of countries that rely heavily on oil imports, which are priced in dollars, such as India, South Korea and Thailand. Several developing countries that need financial injections to cover the payment of their debt, such as Ecuador and Tunisia, are also suffering from the rise in the American currency.
The outperformance of the dollar – up 13% this year in the DXY index – reflects the strength of the American recovery from the pandemic, which has been faster than in Europe or Japan. And it shows that Federal Reserve officials, after misreading price signals for most of last year, lately adjusted faster than their Frankfurt and Tokyo counterparts.
This year, the Fed has hiked rates twice by a total of 75 basis points and is expected to adopt at least three more quarter points at its next meeting later this month. The European Central Bank is expected to raise rates for the first time in 11 years at its July 21 meeting, then only by a quarter of a percentage point. The European key rate should remain in negative territory until September even if inflation reached 8.6% in June.
In Japan, where inflation has long been subdued, the Bank of Japan opted last month to keep its main policy rate at negative 0.1%.
“Central banks have been caught off guard by the surge in inflation and are now reacting at different speeds,” said Marc Chandler, managing director of Bannockburn Global Forex. “The United States is carrying out its most aggressive tightening since 1980, while the Europeans and the Japanese have not budged.”
However, the appreciation of the dollar is not good news for the United States.
American products are becoming more expensive for overseas customers, whose currencies are losing value against the dollar. This hurts big exporters like Boeing, the world’s largest commercial aircraft maker. And giant US corporations are seeing their overseas earnings shrink when converted to dollars, further eroding support for falling stock values.
Last month, Microsoft lowered its guidance for the current quarter, saying the strong dollar would cut its expected earnings by about $250 million.
In April, the software giant was among the first major companies to warn of the strength of the dollar. Executives told investors that the rising dollar in the first three months of the year cost it about $225 million in profits.
In general, US companies derive about 30% of their total revenue from overseas operations, according to Morgan Stanley. Revenues hit by the rising dollar of U.S.-based multinationals could cause them to cut spending in other areas, contributing to the economic slowdown the Fed is trying to engineer.
Some central banks are trying to keep pace with the Fed. On Wednesday, the Bank of Canada surprised markets by raising its key rate by one percentage point to 2.5%, and signaled plans for further increases. The Reserve Bank of New Zealand has also fixed its key rate at the same level, the highest for more than six years. The moves came a day after South Korea’s central bank raised rates by half a percentage point, its biggest move since 1999.
The financial fallout is particularly difficult for European decision-makers. The weaker euro worsens inflation by increasing the cost of goods imported from elsewhere.
Any benefit German exports derive from the weaker currency is being overwhelmed by rising energy costs due to the loss of cheap Russian supplies.
Germany reported its first trade deficit in 30 years this month as Russian limits on natural gas shipments to Europe, sparked by the diplomatic showdown over Ukraine, made German products more expensive and China’s economic slowdown has reduced demand.
Elsewhere, the stress can be even more severe.
On Wednesday, the International Monetary Fund said it had reached a staff-level agreement with Pakistan on a $1.2 billion bailout to help the government deal with a dire economic situation, but which , in return, demand that officials cut energy subsidies – even if inflation runs at 20%.
The global lending agency is also negotiating with other debt-ridden countries like Tunisia, where economic turmoil could turn into social unrest.
According to the Organization for Economic Co-operation and Development, the group of 38 developed countries in Paris, the dollar is now the most overvalued in 30 years.
The currency’s performance defies concerns expressed earlier this year that the Biden administration’s aggressive use of financial sanctions to punish Russia for invading Ukraine would encourage other countries to reduce their dependence on the dollar.
Instead, the dollar remains by far the most widely held global currency, accounting for nearly 59% of total central bank reserves, according to the International Monetary Fund.
The surge in the dollar in recent months has also contributed to the fall in the prices of imported goods.
Friday, the The Department of Labor reported that the price of imports, excluding fuel, fell in June by 0.5%, the second consecutive monthly decline. Over the past year, non-fuel import prices have increased by 4.6%, about half of the overall increase in consumer prices.
“The strong dollar is helping to dampen inflationary pressures,” said Rhea Thomas, senior economist at Wilmington Trust.
Past episodes of major monetary misalignments have triggered outbreaks of protectionism in the United States, as blue-collar workers have rebelled against the loss of jobs to foreign competition or against central bank intervention to reset the dollar, euro or yen value.
At a 1985 meeting at the Plaza Hotel in New York, the United States, Japan, Germany, France, and the United Kingdom agreed to coordinate measures to weaken the dollar in order to make commodities Americans more competitive in world markets.
When the euro was struggling to establish itself in 2000, the central banks of the United States, Europe and Japan agreed to intervene to boost the value of the new currency after it lost almost a third of its original value.
This time, no such intervention is likely. On Tuesday, after meeting with senior Japanese officials, Treasury Secretary Janet L. Yellen brushed aside talk of joint action.
“Our view is that countries like Japan, the United States, [Group of 7 nations]should have market-determined exchange rates, and only in rare and exceptional circumstances is intervention warranted,” Yellen said, adding that she had not discussed such plans with the government. Japanese.
Central banks are more focused on ensuring those who need dollars can get them rather than worrying about how much they will cost, Bannockburn Global Forex’s Chandler said.
The Fed has standing agreements to exchange dollars for foreign currencies with its counterparts in Canada, the United Kingdom, Europe, Japan and Switzerland. At the start of the pandemic in March 2020, the Fed extended these arrangements to nine other central banks, including those of Brazil, Mexico and South Korea, to ensure that markets could function normally despite the sudden shutdown of the economic activity.
“Dollar policy has really changed since the 1980s and 1990s, when there was active intervention,” said economist Steven Kamin, former director of the Fed’s international finance division. “Central banks recognize that what really moves currencies is these substantial economic forces.”
Jeff Stein in Bali, Indonesia, contributed to this report
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