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The dollar will remain strong as long as fundamentals and the Fed allow – News Opener

CAMBRIDGE, Mass. (Project Syndicate)—Despite rampant inflation and slowing growth, the U.S. dollar
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+0.88%

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keeps going from strength to strength. Since May last year, the dollar has risen by 28% against the yen 
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+0.57%

USDJPY and 20% against the pound
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-1.08%
.
It has appreciated 19% against the euro
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-1.35%
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reaching parity for the first time since 2002.

More on the dollar: Why the Fed keeps its focus strictly on the U.S. economy even as its actions could push the whole world into recession

On a weighted-average basis, the dollar is the highest it has been in 20 years. In fact, when judged against a broad set of foreign currencies, it is even higher now than it was in 2002. You would have to go back to 1983-85 to find a time when the dollar was clearly stronger.

Puzzle solved

In a sense, the dollar’s recent rally may seem puzzling. After all, surging inflation and the ongoing economic slowdown should have hurt demand for dollars. But the dollar’s current strength can be explained by the relative resiliency of the U.S. economy and the Federal Reserve’s ongoing commitment to raising interest rates
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True, the U.S. economy has slowed markedly this year. After growing by 5.7% in 2021, GDP reportedly shrank at an annual rate of 1.6% in the first quarter of 2022, followed by a decline of 0.6% in the second quarter, leading many to claim that the United States is in recession.

But employment and other important indicators suggest that the U.S. economy remains exceptionally strong. What is most relevant is that it is stronger than the economies of its major trading partners. The United Kingdom and the European Union, for example, are in the throes of an energy crisis, owing to the war in Ukraine and the subsequent loss of Russian natural gas
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In China, growth has almost vanished as the country grapples with the effects of a bursting housing bubble and pursues its futile zero-COVID policy. And Japan’s GDP has still not recovered to pre-2020 levels.

Terms of trade

Inflation has risen almost everywhere. Inflation can have a negative effect on a country’s aggregate real income when the prices of the goods it imports and consumes rise relative to the prices of the goods it produces and exports. An adverse shift in the terms of trade—reminiscent of the supply shocks of the 1970s—has hit European and East Asian countries that depend on imported fossil fuels
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minerals
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and farm products
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+1.37%
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The greater sensitivity of the terms of trade among trading partners is one factor explaining the appreciation of the dollar against their currencies: The U.S., which has always been a net exporter of minerals and agricultural commodities, is now also a net energy exporter—thanks in part to fracking.

Perhaps the most important explanation for the dollar’s appreciation is the widening of the interest-rate differential between the U.S. and other major countries makes dollar assets more attractive to global investors. In response to inflation, the Fed has been raising U.S. interest rates
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3.610%

 more quickly than has the European Central Bank, including at this week’s meeting of its Federal Open Market Committee. Meanwhile, the Bank of Japan is reluctant to move away from its ultra-loose monetary policy and has continued to hold not only short-term interest rates close to zero, but long-term rates as well.

4 things to watch when the Fed delivers its rate-hike decision

Moreover, with global risk high, the dollar remains a safe haven for nervous investors. Judging by the volume of foreign-exchange trading and the composition of foreign-exchange reserves, the dollar is still the leading global currency. The euro, yen, pound, and yuan
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trail far behind.

Advantages and disadvantages

A soaring dollar has advantages and disadvantages for the U.S. and other countries. For the U.S., it can help bring down inflation but also cause a loss of export competitiveness. For other developed countries, a rising dollar might mean increased trade competitiveness but also higher inflation.

Meanwhile, many developing countries—even commodity exporters that typically benefit from higher global commodity prices—now have to contend with the challenge of currency mismatch. For those with dollar-denominated debts, the greenback’s appreciation means higher debt-servicing costs in local-currency terms.

A stronger U.S. dollar may also encourage other countries to attempt to strengthen their own currencies. In that case, the world might enter a period of “reverse currency wars.” There might even be calls for governments to intervene in the foreign-exchange market to bring the dollar back down to Earth, as the U.S., the U.K., France, West Germany, and Japan did when they concluded the Plaza Accord of 1985.

Nevertheless, the dollar’s current surge is being driven by economic fundamentals. As long as the U.S. economy remains better equipped to handle global inflation than its trading partners are, and as long as the Fed continues to hike interest rates faster than other central banks raise theirs, the dollar will most likely stay strong.

Jeffrey Frankel, professor of capital formation and growth at Harvard University, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He is a research associate at the National Bureau of Economic Research.

This commentary was published with permission of Project SyndicateIn the Dollar We Trust

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