How will the dollar rally end?

The US dollar has had a good run this summer. The Japanese yen and the euro have fallen to their lowest levels against the dollar in two decades; the euro, which for a long time traded more than a dollar, is now approaching parity. The broad dollar index of the Federal Reserve, which calculates its evolution against the currencies of its main trading partners, has almost reached the peak it reached in March 2020 amid the panic unleashed by the start of the coronavirus pandemic. the covid By the way, if you adjust for inflation in the United States and its trading partners, it’s already higher.

This comes despite the fact that the United States is posting its highest annual inflation rate in four decades and its worst trade balance since the global financial crisis. What is happening? Is the dollar on its way to crashing?

Exchange rates are extremely difficult to explain, let alone predict, but there are four major factors that seem to be influencing the movements of the world’s major currencies. Most importantly, the Fed has started to raise interest rates, and now that the US economy is apparently nowhere near a true recession, there is still room for it to tighten policy further.

Despite similarly high inflation in Europe, the European Central Bank is more cautious. This is partly because the economic outlook for the eurozone is more fragile. The ECB is concerned 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 strength of the dollar. The war in Ukraine poses a far more immediate risk to Europe than to the United States, while China’s threatening bluster toward Taiwan is a huge risk to everyone, but primarily neighboring Japan. Recession or not, both Europe and Japan will have to significantly restructure their defense capabilities, with a concomitant increase in long-term military spending.

Then there is the ongoing economic slowdown in China, which affects Europe and Japan far more than the United States. The root causes of China’s growth slowdown — including COVID-zero lockdowns, excesses in the construction sector, crackdowns on the tech sector, and excessive centralization of economic power — are issues on which I have been talking for some time, and I do not see a marked and sustained change of course.

Finally, with energy prices still very high, the fact that the United States is self-sufficient in energy while Europe and Japan are major importers also benefits the dollar.

Some would add that the United States is a safer haven than Europe and Japan. It may be true, even though the United States is mired in a cold civil war that may never end as long as former President Donald Trump is involved. The integration of the eurozone, which promises to advance every time there is a crisis, will be seriously tested if global real interest rates ever start to rise. Inflation in Germany is on track to hit a 70-year high, but with more aggressive rate hikes from the ECB, spreads on Italian government debt could explode.

The current strength of the dollar has profound implications for the global economy. A significant percentage of world trade, perhaps half, is denominated in dollars—and for many countries, that applies to both imports and exports. In this context, a rise in the dollar causes much of the world to cut back on imports, to the point that researchers have detected a statistically significant negative impact on global trade.

A strong dollar threatens to have a particularly brutal effect on emerging markets and developing economies, because private companies and banks in these countries that borrow from foreign investors do so almost exclusively in dollars. And higher interest rates in the United States tend to drive up the interest rates of weaker borrowers disproportionately. In fact, the broad dollar index would have risen even higher if many emerging market central banks had not proactively raised interest rates to stem downward pressure on their domestic currencies. But that adjustment weighs on their domestic economies.

The fact that the largest emerging markets so far have largely tolerated higher US interest rates and a stronger dollar has come as a pleasant surprise. But it remains to be seen how long they will continue to do so if the Fed implements an aggressive tightening path, particularly if commodity prices continue to fall (as my Harvard colleague Jeffrey Frankel has warned) and the US and Europe slip into recession, added to the slowdown in China.

In the short term, a bullish dollar will hurt the United States less than its trading partners, mainly because America’s trade is almost entirely billed in dollars. But a persistently stronger dollar will have a longer-term domestic impact, as the United States will become a relatively more expensive place to produce. It won’t help foreign tourism, still markedly below 2019 levels.

Could the dollar’s recent rise against other major currencies be reversed? To be sure, some major increases in the value of the dollar in the past, including in the mid-1980s and early 2000s, were followed by sharp declines. But once again, exchange rates are notoriously difficult to predict, even over a one-year horizon. A further 15% drop in the euro and yen against the US currency is entirely possible, especially if geopolitical frictions worsen. The only thing that can be said with certainty is that the period of extraordinarily calm exchange rates of major currencies, which began in 2014, is now history.