King dollar rules supreme as the Fed maintains a policy of benign neglect in the currency market, having provided almost limitless access to dollar liquidity for central banks around the world in the past two years.
The greenback is the logical haven for investors seeking financial refuge from a confluence of global shocks that started with the pandemic and has been intensified by Russia’s invasion of Ukraine, culminating in an energy and food price surge.
“It’s our currency, but it’s your problem,” was the 1971 message from John Connally, Richard Nixon’s treasury secretary, to U.S. trading partners dismayed by the dollar’s then weakness.
What was true then remains true today, albeit in the opposite direction with the greenback having risen 6% in April and 13% in the past year to its strongest level for two decades against a basket of major currencies.
The Federal Reserve needs to be mindful of the threat to global growth posed by the U.S. currency’s rapid ascent.
Despite a handful of outliers, including the Brazilian real and the Peruvian sol, the dollar is omnipotent versus pretty much every currency in both the developed and developing world. That’s putting the squeeze on policy makers everywhere to defend their currencies or risk importing yet more inflation into their already beleaguered economies.
The Fed’s monetary policy is dictated by the needs of the domestic economy. With inflation, the most important element of its mandate, surging by 8.5% in March, the U.S. central bank is expected to follow March’s quarter-point interest-rate rise with accelerated half-point increases starting this week.
The futures market anticipates a Fed funds rate of at least 2.5% by year end, up from 0.5% currently; the dollar’s ascent reflects expectations for a shift in interest-rate differential with other countries.
The stronger dollar is also doing the Fed’s work in combating inflation by tightening financial conditions on a trade-weighted basis.
Although the U.S is the world’s largest economy and a huge importer of goods, it is relatively insulated from the global energy and food price shock by its domestic production of fuel and foodstuffs. It also benefits because all major commodities are priced in dollars. It’s everyone else’s problem if raw materials suddenly become more expensive in their respective currencies.
The current weakness in the currencies of Japan and Europe would typically be welcomed for juicing their exports. But the recent slippage in the Chinese yuan, the world’s second-most important trade-weighted currency, puts matters into a different league. All three regions are facing an unusual and potentially intractable problem of imported inflation. There’s a clear and present danger of rising prices slowing global economic growth to the extent that a recession is possible, and stagflation a real risk.
With the Fed’s balance sheet still at nearly $9 trillion, there are plenty of dollars swimming around. The central bank is expected to start actively selling its bond holdings, possibly as soon as this summer, which may reduce overall liquidity and, counterintuitively, make the dollar less of a haven.
Fewer dollars should in theory boost its value, but the world needs to become a better, safer place before the greenback’s uptrend meaningfully reverts. For the sake of the global economy, here’s hoping King Dollar’s crown starts to slip.
