The US dollar has made a steep ascent this summer. The Japanese yen and euro have fallen to their lowest levels in two decades against the greenback.
The euro, which has long been worth more than a dollar, has reached dollar parity. The US Federal Reserve’s trade-weighted dollar index has come close to reviving its March 2020 peak (amid the panic triggered by the onset of the Covid-19 pandemic). Adjusted for inflation in the US and its trading partners, it is even higher.
This is happening even as the US is experiencing its highest annual inflation rate in four decades and its worst trade balance since the global financial crisis. What’s going on there, and is a dollar crash imminent?
Of course, the development of exchange rates is extremely difficult to explain or even to predict. Nonetheless, four key factors currently appear to be driving movements in major world currencies.
Most importantly, the Fed has started raising rates. With the US economy nowhere near a true recession, there is still room for further monetary tightening.
Geopolitical tensions threaten the US less than Europe or Japan
Despite equally high inflation in Europe, the European Central Bank is acting more cautiously. This is partly because the euro area’s economic outlook is more fragile.
The ECB is concerned about Italy’s high level of debt, but also believes that the current pace of energy price inflation will not continue.
Like China, Japan has so far not experienced any significant inflation. The Bank of Japan is unlikely to tighten its monetary policy anytime soon, and the People’s Bank of China lowered interest rates in August.
Another reason for the dollar’s strength is geopolitics. The war in Ukraine poses a far more immediate risk to Europe than it does to the United States.
China’s ominous saber-rattling on Taiwan poses an enormous risk for everyone, but especially for neighboring Japan. Recession or not, both Europe and Japan will need to significantly restructure their defense capabilities, and with that comes an increase in long-term defense spending.
Then there is the ongoing economic downturn in China, which is affecting Europe and Japan far more than the United States.
The root causes of China’s slowing growth – including zero-Covid lockdowns, the aftermath of excessive construction activity, China’s tech crackdown and over-centralization of economic power – are issues I’ve commented on for some time. A steep, sustainable trend reversal is not recognizable to me here.
Finally, as energy prices remain very high, the dollar also benefits from the fact that the US is energy self-sufficient while Europe and Japan are big importers.
Some would add that the US is a safer place than Europe and Japan. That may be true, although the US is currently locked in a cold civil war that cannot end as long as ex-President Donald Trump is still in the game.
In the short term, a rising dollar hurts trading partners more than the US
Euro area integration, which promises to advance whenever there is a crisis, will be severely tested if world real interest rates rise. Inflation in Germany is approaching its highest level in 70 years, but more aggressive rate hikes by the ECB could result in an explosion in spreads on Italian government bonds.
The current dollar strength 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.
Therefore, a rise in the dollar causes large parts of the world to import less – so much less that scientists have found a statistically significant negative impact on world trade.
The strong greenback threatens to have a particularly brutal impact on emerging markets and developing countries, because private companies and banks in these countries that borrow from foreign investors can only do so in dollars.
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Higher US interest rates tend to disproportionately increase interest rates for lower-rated borrowers. In fact, the trade-weighted dollar index would have risen even more if central banks in many emerging markets had not been proactive in raising interest rates to stem downward pressure on their national currencies. Of course, such tightening of monetary policy has negative effects on their national economies.
That the larger emerging markets have largely weathered higher US interest rates and a stronger dollar so far has been a positive surprise.
But how long they will continue to do so if the Fed aggressively tightens monetary policy remains to be seen, especially if, at the same time, commodity prices continue to fall (which my Harvard colleague Jeffrey Frankel has warned against) and, on top of the slowdown in China, the US and Europe in slide the recession.
In the near term, a rising dollar will affect the US less than its trading partners, mainly because US trade is almost exclusively billed in dollars.
But a sustained strong dollar will have longer-term domestic implications by making the US a relatively more expensive manufacturing location. And it won’t help foreign tourism either, where the numbers are still well below those of 2019.
The euro and yen could lose another 15 percent against the dollar
Could the Dollar’s recent surge against the other major currencies be reversed? Of course, in the past, some sharp rises in the dollar’s value were ultimately followed by sharp falls, such as in the mid-1980s and early 2000s.
But to reiterate: Exchange rate developments are difficult to predict, even with a one-year time horizon. In particular, if geopolitical tensions continue to intensify, an additional 15 percent fall in the euro and yen against the US currency is entirely possible.
The only thing that can be said with certainty is that the period of exceptionally stable exchange rates between the major currencies that began in 2014 is now history.
The author: Kenneth Rogoff was Chief Economist at the International Monetary Fund and is now Professor of Economics and Public Policy at Harvard University.
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