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Strong dollar is a major headache for other countries- Newshubweek

Strong dollar is a major headache for other countries
Written by Arindam

American holidaymakers lucky enough to make it abroad this summer may find themselves pleasantly surprised by the might of the dollar — up 10 per cent this year against other major currencies. Cheap ice creams on the beach await. But this strength is bad news, and a side-effect of the US having both a serious central bank and a very serious inflation problem.

The major driver of the dollar’s strength has been the rise in US interest rates — from around zero at the start of the year to, as of this week, between 2.25 and 2.5 per cent. Tightening more quickly than other major economies has powered the surge in the dollar’s value.

The Federal Reserve’s rush for higher rates is merited. Over the past 12 months, the US consumer price index rose by a colossal 9.1 per cent. Jay Powell, chair of the Fed, said: “We’re going to be focused on getting inflation back down . . . That’s something . . . we simply must do.” It is too late to stop the broad price surge that is now well in train, but not too late to fight to keep expectations anchored so inflation returns to earth.

But the Fed’s task is getting more complex: this week, we learnt that the US economy is cooling. How bad is it? The latest GDP figures showed a quarter of slight decline. There is some evidence of higher interest rates starting to bite on investment. But consumers are still spending and the job market remains hot. This is not yet a full-blown recession.

The growing evidence for a slowdown does, however, mean the point where the Fed should stop hiking could be with us quite soon — but not quite yet. Rather unusually, markets also expect that the Fed will start cutting rates quite rapidly, too. In the meantime, however, the gap between rates in the US and the rest of the world is an issue. What is good for the American holiday-maker is, alas, not good for the world.

The strong dollar directly affects America’s trading partners. But one of the peculiarities of the world economy is the extent to which the greenback is used when pricing goods and services among people who have no link to the USA — a recent IMF paper put it at around 40 per cent of invoices from a large sample of countries. Food and fuel — the cornerstones of the inflation surge — are usually quoted in terms of the US currency.

But this is not a mere book-keeping footnote: the IMF also found prices for businesses doing trade between two distant countries can be much more sensitive to the strength of the dollar than the relative levels of the two local currencies. So a strong dollar can create inflationary ripples around the world — including for countries that do not even trade very much with the US.

The upshot of these forces is that other central banks may need to act on the dollar’s strength — because a strong dollar sluices price rises directly into their economies. The Fed remains single-mindedly focused on domestic inflation, and there is little appetite for multilateral action. So the only solution for other central banks is likely to be raising rates a bit higher and perhaps a bit faster than they otherwise would.

There was some good news from the eurozone this week, with stronger than expected numbers on output. This may make it easier for Europe to bear further hikes. But the world’s strong dollar problem speaks to the extraordinary complexity of this moment for central banks. It is not enough to cope with war in Europe, a commodity surge and the aftershocks of an epochal pandemic. Now they need to worry about whether the people in Washington are accidentally sending more inflation their way, along with America’s big-spending holidaymakers.

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Arindam

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