The U.S. dollar continues to be compared to a ‘wrecking ball’ when it comes to the economic and trade havoc wrought by its outsized 2022 rally.
But there’s not much central bankers and other economic policymakers can do, warned Paul F. Gruenwald, chief global economist at S&P Global, in a Thursday note. Tackling the factors that are really driving the dollar higher will require politicians to do the heavy lifting, he argued.
See: Why an epic US dollar rally could be a ‘wrecking ball’ for financial markets
So how strong is the dollar? The ICE US Dollar Index DXY,
a measure of the currency against a basket of six major rivals, hit a 20-year high of 115 last month before falling back in early October. It remains up by more than 17% since the start of the year and by almost 20% over the last 12 months.
The British pound GBPUSD,
fell last week to an all-time low against the US dollar as the UK plunged into a fiscal crisis. EURUSD euro,
fell below parity against the dollar, with the euro zone set to suffer a sharp winter slowdown due to the energy shock created by Russia’s invasion of Ukraine. The Japanese yen recently traded at its lowest against the US dollar from 1998, prompting a rare round of Bank of Japan intervention.
See: Don’t look for a stock market bottom until a rising dollar has calmed down. Here’s why.
Why is a strong dollar a problem? While a stronger dollar helps contain inflation in the United States, the depreciation of rival currencies amplifies inflation in these economies. The magnitude and speed of the dollar’s rise has raised fears of market disruption and stress in emerging and developing economies that carry a high proportion of dollar-denominated debt. Dollar gains are also seen as negative for large-cap U.S. multinationals that rely on international sales.
Read below what Gruenwald had to say about the four options available to countries and economies struggling to fend off a strong dollar – and why none of them are ideal:
Come out of the storm. It’s not really an option. Episodes of excessive dollar strength can last for years. Allowing an exchange rate to depreciate will lead to higher inflation, higher debt servicing costs, lower disposable income and reduced credibility for policy makers. Moreover, it is likely to have costs for the national political economy, as policy makers are seen as having to ‘do something’.
Lean against the wind using reserves. It’s unlikely 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 short-lived. Markets can and will test policymakers, and the result will likely be a weaker currency and fewer reserves. Reserves are normally used to smooth market volatility during turbulent times, but not to combat continuing waves of depreciation pressures.
Imposing capital controls. Restricting access to foreign currencies is a tempting but probably ineffective approach. The likely result is a black market and double or multiple exchange rates, with only “insiders” having access to foreign currencies. This will lead to market distortion and dislocation. It will also damage reputation and limit future use of the currency for international transactions.
Raise interest rates to compensate for depreciation. This is the classic response to easing financial conditions. However, this is also problematic. If monetary policy makers are “doing the right thing” by raising rates to tighten financial conditions and reduce inflation to ensure sustainable growth, then an unwanted currency depreciation means rates must rise. This is a consequence of Mundell’s well-known trilemma. Essentially, this means higher rates and lower output and employment due to someone else’s inflation being imported. [The Mundell trilemma is the concept that a country can’t maintain a flexible monetary policy, a fixed exchange rate, and free capital flows at the same time — it must choose two of the three.]
There are also “global options”, notes the economist. These include dollar swap lines with other countries, such as those that were extended or launched in early 2020 as a global run on the US currency sent the greenback higher as the COVID-19 pandemic has hit the global economy. Although swap lines have proven effective in such situations, it is not clear that they would be appropriate for soaring dollar valuations, Gruenwald wrote, “because they are akin to additional reserves: they are likely to be exhausted to defend an exchange rate level”.
And then there’s the big one. A Plaza Accord-type agreement between major economies. The Plaza Accord of 1985 saw the Federal Reserve and the central banks of Germany, the United Kingdom, France and Japan agree to intervene to drive down the value of the US dollar, which, as described Gruenwald, had known the “mother of all… appreciations. ”
Related: Why the soaring dollar raises questions — and doubts — about a Plaza Accord-style intervention
But even if the current pain of dollar strength becomes evident and to the upside, DXY is still three or four standard deviations from its 1985 high, he said, noting that the focus then was on trade imbalances and that China was not part of the discussion given its small economy at the time.
At some point, the pain may become too much to bear.
“Ultimately, the resolution will depend not only on economics but also on politics,” Gruenwald wrote.
Dollar strength “becomes excessive when it begins to negatively impact other economies more than it benefits the United States. Exact measurement of this is difficult,
but one way to assess it is to ask: what would a benevolent global policymaker prescribe? ” he wrote.
At some point, a strong dollar becomes less than optimal for all parties involved, “and if markets don’t correct, there will be a political element to the solution,” Gruenwald wrote.
The extreme – and persistent – high level of the US dollar in the 1980s was finally brought down thanks to the Plaza Accord, he noted. “The actors may be different this time around, but the endgame could end up looking the same.”