The soaring dollar has prompted some analysts and investors to forecast a new period of “reverse currency wars”, with many central banks abandoning a long-held preference for weaker exchange rates.
The new momentum marks a break with the period of low inflation that followed the global financial crisis of 2007-09, when historically low interest rates and large-scale asset purchases – which were partly aimed at stimulating growth thanks to a weaker currency – sparked accusations that some economic policymakers were pursuing a currency war.
But in the global explosion of price growth following the coronavirus pandemic, further stoked by Russia’s invasion of Ukraine, central bankers’ attention has shifted from encouraging growth to reduction in inflation.
“We are now in a world where having a stronger currency and offsetting the driving forces of inflation is something policymakers welcome,” said Mark McCormick, head of currency strategy at TD Securities.
The dollar hit its highest level against a basket of rival currencies in 20 years this week as traders reacted to the Federal Reserve’s attempt to cool inflation with sharp rate hikes. But where once central bankers outside the United States might have embraced the raging dollar, they now believe exchange rate swings have added further pressure to keep pace with the Fed, McCormick argues.
A weaker currency drives up inflation by raising the price of imported goods and services. According to Goldman Sachs analysts, who have identified a new era of “reverse currency wars”, central banks in major developed economies must raise interest rates by an average of another 0.1 percentage points to compensate for a drop in 1% of their currencies.
The euro hit a five-year low against the dollar at under $1.05 last week, sparking fresh speculation that it could fall to par with the US currency as the fallout from the conflict in Ukraine dampens the economy. euro area economy. The 7% decline so far this year has not gone unnoticed at the European Central Bank.
Isabel Schnabel, an influential member of the ECB’s governing council, said in an interview this week that the central bank was “closely monitoring” the inflationary effects of a weaker euro, although she reiterated the mantra that the central bank does not target the exchange rate.
Yet, given the proximity of their economies to Ukraine and their greater reliance on energy imports, investors increasingly believe that European central banks will struggle to keep pace with the Fed. The pound fell to its lowest level in two years this week, even after the Bank of England raised rates for its fourth consecutive meeting, as it also warned that the UK was heading into a recession later during this year.
Sterling weakness could start to worry BoE policymakers, Goldman Sachs strategists warned ahead of the meeting. “At some point, the ‘reverse currency wars’ mentality could become more pervasive in the minds of the BoE, with currency weakness exacerbating an already bleak inflation outlook,” Goldman wrote in a note to clients. .
The Swiss National Bank, for so long one of the currency’s most active warriors, with its policy of not allowing the franc to appreciate too much, has also changed its tune. SNB board member Andrea Maechler said this week that a strong franc has helped stave off inflation, which has risen in Switzerland this year but far less than in the neighboring eurozone.
The Bank of Japan has largely steered clear of renewed aversion to a weaker currency, sticking to its ultra-loose monetary policy even as the yen experiences a historic plunge. Even so, the yen’s rapid decline has sparked growing speculation that Japan’s finance ministry may intervene in markets to support the currency for the first time since 1998.
The strong dollar has also created problems in emerging countries, especially those with large dollar-denominated debt. Even before the surge in the dollar this year, around 60% of low-income countries were at risk of over-indebtedness, according to the IMF.
“The strength of the dollar is part of why you’re seeing very limited investment in emerging markets today. Because it’s a big risk. Dollar exposure in most emerging markets today is substantial, not only at the sovereign level, but also at the corporate level,” said Rick Rieder, chief investment officer for global fixed income at BlackRock.
According to Karl Schamotta, chief market strategist at Corpay, these tensions are the latest reminder that the dollar is “our currency, but it’s your problem”, in the words of former US Treasury Secretary John Connally in the early 1970s.
Given the dollar’s unique role at the heart of the global financial system, its strength makes it harder for businesses and households to access finance in many economies outside of the United States.
“As the dollar rises, we are seeing a tightening of global financial conditions,” Schamotta said. “The United States continues to make the weather of the world.”