Implications of the Strengthening Dollar for the World Economy

In 2022, we have seen a significant strengthening of the US dollar (USD) against all currencies, in both emerging and developing economies. This widespread USD appreciation is partly the result of a very aggressive monetary tightening cycle by the US Federal Reserve (Fed), driven by a reversal of the unprecedented inflation of recent years. But how did we get to this point? Why does a strong US dollar matter for the global economy? And, above all, when is the situation likely to reverse?

It is also true that the energy crisis caused by Russia's invasion of Ukraine is being solved by the bottlenecks created by the pandemic, and that central banks cannot prevail at this time. The sanctions that remain in place have increased the cost of energy and, in turn, the prices of fertiliser, food and other materials central to the global escalation.

Monetary policy

These pressures on basic inputs are spreading to most goods and services in the consumption basket, eroding household purchasing power. When wages have to be adjusted to compensate for rising prices, there is a surge in precautionary inflation as there are generators of the so-called second round or snowball effect. The main danger of inflation is its strong inertia: once it accelerates, it is very difficult to stabilise it again.

That's where central banks come to the rescue with a classic recipe: making money more expensive to curb consumption and private investment. The Fed was one of the first authorities to propose a scenario of tight monetary constraints: interest rate hikes totalled almost 400 basis points with another 100 on the table. The remission rate was permanently at 5 per cent until the end of 2023, making high inflation more persistent than ever.

Currencies and interest rates

For the FX market, this is a crucial factor: investments are more efficient when the correlation of spreads is higher and a deterministic risk profile is achieved. Capital inflows lead to rate hikes in favour of spreads with the best correlations. The support of the Fed, which is much more bullish than other central banks, has caused the US dollar to strengthen against many of its G10 peers. This partly explains why the dollar has reached more than two-decade highs against the euro or the yen, where monetary tightening has been slower or non-existent, respectively.

However, the relative strength of the US dollar was not only due to differential interactions: on the one hand, in the face of rising geopolitical tensions and the global economic downturn, huge demand for safe haven recovered ‘bargain’ currencies such as the Canadian dollar; on the other hand, the dollar was significantly reputationally influenced by the terms of trade in the US, which became a net exporter of energy due to the energy crisis in Europe.

What does a strong dollar mean for the world economy?

The consequences of a strong US dollar are not harmless for the world economy, which is interconnected through multiple channels of trade, transactions and investment. Firstly, a more expensive dollar increases the value of raw materials in the money supply of households and the currency eliminates these factors of production for economic activity. For commodity-dependent economies, the strengthening of the US dollar has translated into accelerating inflation, with potentially favourable effects on economic growth and the development of businesses and companies. The European economy is a prime example of this, as around 50 per cent of total imports are dollar-denominated.

Second, prolonged periods of dollar strength have led to a sharp decline in investment outside the US, particularly in emerging economies. Combined with high global inflation and tight monetary policy, these operations become much more vulnerable to experimentation and macroeconomic instability.

A third challenge is the debt sustainability of high dollar leveraged economies, typically also emerging economies. The appreciation of the dollar de facto multiplies the amount of money spent and its financial cost, creating a dynamic of effort that has no implications for economic growth. After a year of strong US dollar appreciation, the currency has begun to show signs of exhaustion. This is a reflection of the Fed's softer communication of near-term monetary policy decisions, with rate hikes likely to be more subdued than in the past. A 50 or 25 basis point rate hike gives a sense that the level of interest rates is near, and with it the peak of dollar strength. As a consequence, the negative performance of the USD DXY index combined with the declining relativity of the overall US inflation numbers.

However, if the Fed's measures to mitigate the relentless dollar appreciation are able to turn the tide, the likelihood of an accelerated correction in the currency is very high. There is no meaningful scenario in which the Fed is able to fix the level of labour market rates. In addition, the prevailing risks in the geopolitical environment (in particular the tense energy market situation) are not sufficient to ensure a positive impact on labour market developments. Finally, the uncertain growth prospects in China, a key driver of the global economy, are also not optimistic. At the same time, as a concession, this risk situation still favours investors' preference for a “safe haven” such as the US dollar.