Dollar pain spreads from emerging to developed economies
Advanced economies are hitting multi-decade highs from dollar appreciation that was more familiar to their emerging market peers.
Driven by the Federal Reserve’s most aggressive tightening cycle in more than a generation, the stronger greenback is pushing rival currencies lower, raising the price of imported goods, tightening financial conditions and raising inflation in other economies.
That is increasing pressure on other central banks to raise interest rates just as an energy crisis and rising consumer prices hamper Europe’s economy and rising borrowing costs cool housing markets in Australia, Canada and New Zealand. Yet their ability to influence the dollar’s strength is limited, meaning there is little chance of near-term relief.
While the global surge from Fed tightening is not new, this is the first episode in recent years where the strength of the serious dollar has been more significant against developed-country currencies as a group than against developing economies.
“A strong dollar usually comes with higher short- and long-term interest rates in the U.S., or with pressures on global markets and a flight to the dollar’s perceived safety,” said Maurice Obstfeld, senior fellow at the Peterson Institute for International Economics. “These tight financial conditions are slowing advanced economies everywhere.”
The Fed’s trade-weighted dollar index versus advanced economies is up 10% this year, the strongest since 2002, while the emerging market gauge is up a more modest 3.7% and below its peak since the 2020 pandemic.
While some of the world’s worst-performing currencies this year are from developing economies like Sri Lanka, the outperformance of commodity-backed currencies like Brazil’s real and Russia’s ruble bolstered the EM grouping.
“Just by raising policy rates, other countries cannot stop devaluing their currencies,” said Sayuri Shirai, a former Bank of Japan board member who is now a professor at Keio University.
Because “the strength of the dollar not only reflects expectations of a federal funds rate hike this year – and thus higher demand for US fixed-income assets – but also the risk of a global recession due to a previously-expected policy rate hike. The world,” he said.
That problem will be illustrated in the coming days as the European Central Bank considers a record 75 basis-point rate hike as it struggles with record inflation and the euro below parity with the dollar. The Bank of Canada said it would raise rates by the same amount and the Reserve Bank of Australia raised rates by just half a percentage point.
In the UK – which is already in recession, according to a business lobby group – the Bank of England may tighten further on September 15 as it faces a loss of investor confidence that has pushed the pound to its lowest level since 1985. .
And the yen’s plunge to a quarter-century low is making it increasingly difficult for BOJ Governor Haruhiko Kuroda to stick to his line that massive monetary support is needed, even in the face of rising prices.
With the Fed yet to hike, relief on the monetary front for the world’s central bankers may come only when US counterparts rein in consumer prices.
Since it became clear that the Fed would switch to tightening mode about a year ago, developed-market currencies have struggled at least as much as their emerging-nation counterparts. Across the 31 major exchange rates tracked by Bloomberg, four of the 10 best performers improved and only one, the Canadian dollar, was among the 10 biggest losers.
For central banks like the ECB, whose currency is most traded in the dollar, the current energy crisis has provided its policymakers with a particularly sharp reminder of the euro’s role as a channel for inflation — not least because of the greenback’s use in determining global commodity prices.
“I would argue that, in this particular situation of energy-supply shocks, the exchange rate is more important,” ECB Executive Board member Isabelle Schnabel told Reuters last month when asked about previous research showing that the pass-through of inflation has been low.
Japan, whose currency is the second most traded against the dollar, is also feeling the loss. After crossing the 143 level, the currency is not far from the 146 mark that supported it for joint action with the US in 1998. It also raises the prospect of inflation topping 3% — above Kuroda’s 2% target.
Although the BOJ chief stressed that the recent supply-driven rise in consumer prices will not last, households and businesses are becoming more volatile as the yen’s dive turbo-charges power and increases in import costs. Officials are warning against excessive volatility.
“Sudden changes in foreign-exchange markets are not desirable,” Japanese Finance Minister Shunichi Suzuki told reporters after an online meeting of G-7 finance ministers. “Recent moves in foreign-exchange markets are a bit on the big side,” he said.
The big concern for many countries may be that local rate hikes may do little to slam the brakes on their nose-diving currencies as their economies look more fragile than those of the United States.
The British pound is on the brink of hitting its March 2020 lows, despite swap traders pricing in the BOE to out-hike the Fed, betting the UK benchmark will top 4.25% in six months, compared to 4% in the US. It will be over by then
While many emerging economies have experienced rising rate and inflation shocks, they have broadly weathered the Fed’s hiking cycle better than in past episodes, helped at least in part by beefier foreign exchange reserves and faster moves by the Fed to raise rates ahead of the Fed.
Some, such as Chile and India, have also intervened to support their currencies — something that is politically difficult for developed-nation peers.
One possibility for relief is a slowdown in the U.S. economy that takes the steam out of the Fed’s tightening pace and the dollar weakens as a result of the hike.
Fed officials will choose the size of a rate hike at their Sept. 20-21 policy meeting likely to be strongly influenced by the latest monthly reading of consumer prices from Sept. 13.
For now, the Fed has indicated that the relief may end some way off, requiring policy tightening for some time to control inflation.
“The problem for advanced-economy policymakers will intensify if the dollar continues to rally,” said Mansoor Mohiuddin, chief economist at Bank of Singapore Ltd. And growth is slowing.”
