By Kenneth Rogoff
The US dollar has been on a tear this summer. The Japanese yen and the euro have fallen to their lowest levels against the greenback in two decades; the euro, long worth more than one dollar, is now hovering close to parity. The US Federal Reserve’s broad trade-weighted dollar index has almost re-attained the peak it reached in March 2020 amid the panic triggered by the start of the COVID-19 pandemic. In fact, if one adjusts for inflation in the United States and its trading partners, it is already higher.
This is happening despite the US recording its highest annual inflation rate in four decades and its worst trade balance since the global financial crisis. What is going on, and is the dollar set to plummet?
While acknowledging that exchange rates are extremely difficult to explain, much less predict, four major factors seem to be influencing the movements of the world’s major currencies. Most importantly, the Fed has begun hiking interest rates, and with the US economy seemingly nowhere near a true recession, there is still room for it to tighten policy further.
Despite equally high inflation in Europe, the European Central Bank is being more cautious. This is partly because the economic outlook for the eurozone is more fragile. The ECB is worried about Italy’s high debt levels, but also believes that current rates of energy-price inflation will not continue. Japan, like China, has so far not experienced significant inflation. The Bank of Japan is unlikely to tighten policy anytime soon, and the People’s Bank of China cut rates in August.
Geopolitics is also a factor behind the dollar’s strength. The war in Ukraine presents a much more immediate risk to Europe than to the US, while China’s ominous saber-rattling toward Taiwan is a huge risk for everyone, but most of all to neighboring Japan. Recession or not, both Europe and Japan will have to restructure their defense capabilities significantly, with a concomitant rise in long-term military expenditures.
Then there is the ongoing economic slowdown in China, which affects Europe and Japan far more than America. The root causes of China’s decelerating growth – including zero-COVID lockdowns, the legacy of overbuilding, a crackdown on the tech sector, and over-centralization of economic power – are issues I have been commenting on for some time, and I do not see a sharp, sustained turnaround.
Some would add that the US is a safer haven than Europe and Japan. That may be true, despite America being mired in a cold civil war that can have no end as long as former President Donald Trump is in the mix. Eurozone integration, which promises to advance whenever there is a crisis, will be sorely tested if global real interest rates ever start rising. Inflation in Germany is on track to hit a 70-year high, but more aggressive ECB interest-rate hikes could cause spreads on Italian government debt to explode.
The dollar’s current strength has profound implications for the global economy. A large share of world trade, perhaps half, is denominated in dollars – and for many countries, that applies to both imports and exports. As such, a rise in the dollar causes much of the world to cut back on imports, so much so that researchers have found a statistically significant negative impact on global trade.
A strong greenback risks having a particularly brutal effect on emerging markets and developing economies, because private firms and banks in these countries that borrow from foreign investors can do so pretty much only in dollars. And higher US interest rates tend to push up weaker borrowers’ interest rates disproportionately. In fact, the broad dollar index would have risen even more had many emerging-market central banks not proactively raised interest rates to stem downward pressure on national currencies. But such tightening of course weighs on their domestic economies.
The fact that bigger emerging markets have so far largely withstood higher US interest rates and the stronger dollar has been something of a pleasant surprise. But how long they will continue to do so if the Fed pursues an aggressive tightening path remains to be seen, particularly if commodity prices simultaneously fall further (as my Harvard colleague Jeffrey Frankel has warned) and the US and Europe slide into recession, on top of the slowdown in China.
In the near term, a buoyant dollar will affect America less severely than its trading partners, mainly because US trade is almost entirely invoiced in dollars. But a persistently stronger dollar will have a longer-term domestic impact, as the US will become a relatively more expensive place to produce. It won’t help foreign tourism, still sharply down from 2019.
Might the dollar’s recent surge against other major currencies go into reverse? To be sure, some previous big run-ups in the dollar’s value, including in the mid-1980s and the early 2000s, were eventually followed by sharp declines. But, again, exchange rates are notoriously difficult to predict, even on a one-year horizon. A further 15% fall in the euro and the yen against the US currency is entirely possible, particularly if geopolitical frictions take another turn for the worse. The only thing that can be said with certainty is that the period of extraordinarily quiescent major-currency exchange rates, beginning back in 2014, is now history.
Source: Project Syndicate