The U.S. Dollar Is On A Roll

The U.S. currency is on a trajectory not seen in two decades. The dollar has strengthened across the board this year, with much of the action happening after the Federal Reserve's first rate hike in March (see chart 1). Subsequent hikes and the hawkishness of the Fed's language have accelerated this trend.

Chart 1

While U.S. dollar strength has been broad-based, it has not been uniform. The yen and pound sterling have depreciated the most, reflecting the former's attraction as a funding currency (the Bank of Japan seems unlikely to raise rates soon) and the latter's policy uncertainty. Some emerging markets have depreciated by less than the average, owing to their higher policy rates (many Latin American countries) and interventions (as seen in India). The euro-dollar rate is below parity for the first time since 2002.

Why is this happening? The drivers of this dollar surge are interest rate differentials and safe haven demand. Relative (risk-adjusted) interest rates are a strong factor in capital flows. Given that the U.S. has a relatively large overheating problem and a relatively large core inflation problem, higher policy rate hikes are required. The Fed's latest dot plots suggest that the terminal rate for this cycle is about 4.5%; S&P Global Ratings think that this corresponds to a "Goldilocks", soft-landing scenario. Safe haven demand is the other key determinant, including that the U.S. is relatively unaffected by ongoing geopolitical tensions. The U.S. dollar remains the world's risk-free currency, so in times of heightened geopolitical tension or just general de-risking, the U.S. dollar tends to strengthen. The interesting twist at this juncture is that almost every other central bank has inflation issues and is also hiking rates.

An Unusual Scenario--But Not Unprecedented

Episodes of outsized dollar strength are few and far between, but we have seen this situation before. A common lens through which to view dollar strength is the "DXY" index, which is widely used in the financial markets and press. This longstanding index--which is not trade-weighted--tracks the U.S. dollar against a basket that includes the euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona. It was first developed and based in 1973, and modified in the late 1990s to include the euro. Fifty years of DXY are plotted in chart 2.

Chart 2

Some key observations about the behavior of DXY are as follows:

• The average value of the index over the past 50 years is about 97, and the series tends to eventually return to that value, suggesting some form of mean reversion; in the five-year run up to the COVID-19 pandemic, the index was broadly stable at close to its long-term average.
• The index has seen two long-lasting periods of dollar strength: the early to mid-1980s and the early 2000s. In the former, U.S. rates were very high because of the Volcker disinflation strategy, and the U.S. economy was accelerating on the back of large tax cuts, with growing concerns about the twin deficits. In the early 2000s, U.S. rates were fairly low, but the U.S. economy was outperforming, and the dot-com boom was at least initially in full swing.
• The index can remain above or below its long-run average for large periods of time. The two periods of dollar strength above lasted for more than half a decade, while the post-dot-com period of dollar weakness lasted more than a decade.

The rising dollar strength in 2022 has triggered discussions as to whether we are entering another lengthy period of dollar appreciation. Indeed, the DXY is now within striking distance of the peak of early 2002. While such periods are difficult to forecast--empirically, exchange rates are seen by many economists to follow a "random walk"--we appear to be entering a new phase. The drivers are the relatively aggressive tightening path of the U.S. Federal Reserve combined with the geopolitical uncertainties related to the Russia-Ukraine conflict. Our working assumption is that U.S. dollar strength is likely to persist if those two factors are in place.

"Our Currency, Your Problem": A Field Guide For Innocent Bystanders

The current situation harks back to the famous 1971 comment by U.S. Treasury Secretary John Connally, who told his European counterparts: "The dollar is our currency, but it is your problem." Even for policymakers in other economies who are "doing the right thing"--arguably innocent bystanders, for the most part--the strong U.S. dollar complicates their policymaking. As a reminder, exchange rates are relative prices, so winners (appreciators) co-exist with losers (depreciators). We see the main effects as follows:

A weaker currency imports global inflation

A depreciated local currency translates into a higher cost of imports. This will add to domestic inflation pressures. It also lowers the disposable income of domestic residents. The opposite is true in the economy whose currency is appreciating--they are exporting their inflation and enjoying lower import costs and higher real incomes.

A weaker currency imports an unwanted easing of monetary conditions

Raising local policy rates tightens monetary conditions through three channels: higher borrowing costs, lower asset prices, and lower import costs. The third channel is negated by a depreciating currency. For policymakers fighting high inflation by raising rates to tighten monetary conditions, a weaker currency resulting from a strong U.S. dollar is a problem: it implies that higher local rates are required to attain the desired monetary conditions.

Chart 3

A weaker currency risks capital outflows

A weaker domestic currency also affects expectations. If the risk-adjusted returns of U.S. dollar assets are higher and the expectation is that the local currency will continue to depreciate, then capital outflows become more likely, including for carry trades. These outflows will of course drive the local currency lower, so this channel has a self-fulfilling element to it.

A weaker currency raises the cost of servicing U.S. dollar debt

This effect will depend on the proportion of unhedged U.S. dollar liabilities--principal and interest payments--as well as the amount of debt coming due: the maturity wall. The exchange rate effect will come on top of higher market (risk-free plus spreads) interest rates stemming from Fed tightening.

A weaker local currency will spur export competitiveness

This is an upside, yet we think it is unlikely to compensate for the negative effects of the other factors. Any competitiveness gain would come against a background of weakening global demand. Then again, if the dollar surge is long lasting, this could eventually become a benefit--something that economists describe as the "J-curve effect". That said, U.S. competitiveness would decline from a persistently strong dollar, and this indeed was an issue in the 1980s when U.S. exporters were complaining.

A weaker currency affects international investment positions

Finally, we should also consider stocks as well as flows, and the effects of a weaker currency on the international investment position. For net creditors, the strong dollar means higher international assets measured in local currency (to the extent those assets are denominated in dollars). Net debtors will have the opposite effects, and see their next liabilities rise. While the global international investment position is zero (by definition), there is a spectrum of individual country positions. Japan, Germany, and China all have large surpluses—often investing outside their countries where returns are often higher--while the U.S. has by far the largest net liability position, in part because of its role as the issuer of the global reserve currency and asset.

There Are Many Options, But No Simple Solutions

The current juncture of slowing global growth and still-high inflation provides a troubling backdrop for policymakers facing a wave of U.S. dollar strength. There are no easy options. The unwelcome dollar strength not only causes macro policy challenges, but it also carries potential political economy costs.

Here is a short list of options at both the domestic and international levels.

Domestic options in recipient countries

Ride out the storm.   This is not really an option. Episodes of outsized dollar strength can last for years. Letting the exchange rate depreciate will lead to higher inflation, higher debt servicing costs, lower disposable income and reduced policymaker credibility. Moreover, it is likely to have domestic pollical economy costs as policy makers are seen as needing to "do something".

Lean against the wind by using reserves.   This is not likely to be a winning strategy either. Intervention can slow the rate of depreciation, but if the pressures are large and sustained these victories will be fleeting. Markets can and will test policymakers, and the result is likely to be a weaker currency and fewer reserves. Reserves are normally used to smooth market volatility in times of turbulence, but not for fighting ongoing waves of deprecation pressures.

Impose capital controls.   Restricting access to foreign exchange is a tempting but likely ineffective approach. The probable outcome is a black market and dual or multiple exchange rates, with only "insiders" getting access to access foreign currency. This will lead to market distortion and dislocation. It will also create reputational damage and limit the future use of the currency for international transactions.

Raise rates to offset the deprecation.   This is the textbook response to loosening financial conditions. However, this is also problematic. If monetary policymakers are "doing the right thing" in terms of raising rates to tighten financial conditions and lower inflation to ensure sustainable growth, then unwanted currency deprecation means rates must go higher. This is a consequence of the well-known Mundell trilemma. In essence, this means higher rates and lower output and employment as a result of importing someone else's inflation.

Global options

U.S. Fed Issues swap lines to various central banks.   This is a way to overcome temporary dollar shortages in overseas markets. These shortages typically arise in periods of market stress when U.S. dollar asset markets dry up as agents stock up on risk-free assets. Swap lines can and have been effective in addressing U.S. dollar liquidity stress in offshore markets, but whether they are appropriate for elevated U.S. dollar valuation events is unclear, because they are akin to extra reserves: they are likely to be depleted in defending an exchange rate level.

Implement a 21st century Plaza Accord.   The early and mid-1980s saw the mother of all U.S dollar appreciations, as seen in chart 2. The economic and political fallout from that event eventually led to the Plaza Accord of September 1985, where the central banks of the U.S., Germany, the U.K., France, and Japan agreed to intervene to bring down the value of the U.S. dollar. While the current pain of dollar strength is beginning to become evident and rising, we are still three to four standard deviations away from the peak DXY in 1985. Importantly, the focus then was on trade imbalances, and China was absent owing to its small economy at that time.

The End Game Is About More Than Economics And Markets

Ultimately, resolution will depend not just on economics but also politics. U.S. dollar strength derives in part from U.S. economic strength and historically earned safe haven status. The U.S. dollar remains the world's global reserve currency (with about 70% of the global total) and U.S. Treasuries remain the world's risk-free asset. This is despite the well-documented relative decline of the U.S. At present, and in the foreseeable future, there simply is no alternative.

But U.S. dollar strength reflects geopolitical factors as well, and in both directions. We see this in relation to the Russia-Ukraine conflict and the resulting demand for risk-free assets. This tends to bolster the dollar. But there are also tensions with emerging markets and even some advanced country policymakers whose inflation-fighting efforts are being made more difficult by a U.S. dollar level that seems difficult to justify by pure fundamentals. This is generating some push back.

What is the outcome? The resulting dollar strength becomes excessive when it starts to negatively impact other economies more than it benefits the U.S. The exact measurement of this is difficult, but one way to gauge it is to ask: What would a global, benevolent policymaker prescribe? At some point a strong dollar becomes less than optimal for all involved, and if markets do not correct, the solution will have a political element. The extreme--and persistently--high U.S. dollar of the 1980s was in the end brought down by policymakers through the Plaza Accord. The actors may be different this time around, but the end game might end up looking the same.