Source: RMB Transactions and Research
Despite signs of trouble in the U.S. economy, including soaring inflation, falling stock prices and faltering consumer confidence, one important indicator is showing America’s strength: the dollar.
Even as the Dow fell, the U.S. dollar index remained firm, up 8% this year. The U.S. dollar has appreciated 7% against the yuan, with most of the gains in the past month. The dollar has climbed 12% against the yen and 10% against the Swiss franc over the same period.
Figure 1: USD/CNY
Chart 2: USD/JPY
Changes in exchange rates have important economic implications. A stronger currency in a country should make it cheaper to import goods, which should help curb inflation. From this point of view, the appreciation of the dollar will make the Fed’s job a little easier, and may dilute the Fed’s urge to aggressively raise interest rates to dampen demand and prevent consumer prices from rising.
The strength of the dollar is supported by a number of factors. Interest rates in the U.S. are significantly higher than elsewhere in the world. For example, 10-year U.S. Treasuries yield 2.9%, compared to 10-year German bunds, British bunds, and Japanese bunds, which yield 0.95%, 1.7%, and 0.2%, respectively. Higher returns make investors willing to put their money in the United States.
“Compared to other developed countries, the Fed has been raising rates very fast and very aggressively,” said Kristin Forbes, a professor of economics at the Massachusetts Institute of Technology and a former member of the Bank of England’s monetary policy committee. She said. A stronger currency is a natural consequence.
The broader picture is that the economic situation elsewhere is even worse than in the United States. The European economy was hit hard by the Russian invasion of Ukraine.
At the same time, China’s economic growth engine is being hampered by the coronavirus lockdown, and a sluggish property market is hurting banks and homebuyers, whose investment homes are falling in price. The Shanghai Composite Index has fallen 16% this year. Stock indexes in Shenzhen and Hong Kong fell even more.
The International Monetary Fund (IMF) expects China’s economy to grow by 4.4% this year, half of last year’s growth rate and close to the 3.7% expected in the United States. If the forecast is correct, it would be the closest economic growth between the two countries since 1989; JP Morgan economists expect the U.S. to outpace China’s in the April-June period. This is another rare case.
The renminbi has depreciated sharply in the past month, a sign that investors in China are moving assets abroad and a reflection of the need for foreign trade companies to use the renminbi to boost exports amid a faltering domestic economy.
Looking back at the U.S., the downside of a strong dollar is that it makes exports more expensive, inhibiting growth. But the upside is that a strong dollar helps keep inflation in check. Think of the many items the U.S. imports from places like China or Vietnam, such as sneakers and dining tables. A rising dollar makes imports cheaper.
This may be particularly relevant to the current situation. The cost of imported goods has soared at double-digit rates in 10 of the past 12 months, according to the U.S. Department of Labor. The COVID-19 pandemic has disrupted global supply chains, causing Americans to stay at home and increase spending on durable goods instead of going to movie theaters, hotels or restaurants.
A stronger dollar should keep import costs down. For this part of the saved import cost, companies that rely on imported components may choose to increase the profit of domestic sales instead of reducing the price of the product, but some of the cost savings should eventually benefit consumers. Economist Owen Humpage estimated in 2015 that a broad and sustained rise of 1 percent in the dollar could reduce the price of non-oil imports by 0.3 percent over six months.
When the Fed tries to keep inflation down, it relies not only on the immediate effects of higher short-term interest rates, but also on the knock-on effects of falling stock prices, rising long-term rates on home mortgages and corporate debt, and a strong dollar.
An index of financial conditions maintained by Roberto Perli, head of global policy analysis at investment firm Piper Sandler, captures the combined impact of these changes. Perli said the index showed that financial conditions are now as tight as they were in 2012, shortly after the 2007-2009 financial crisis.
That’s a sea change, Perli said. A year ago, low interest rates, a buoyant stock market and a modestly valued dollar meant financial conditions were more favorable for economic growth than at any other time in more than 20 years.
The Fed has raised short-term interest rates by a total of 75 basis points so far this year. But a Goldman Sachs index of financial conditions shows financial conditions now look as if the Fed had raised rates by 225 basis points, as the dollar and stock market volatility magnified.
“The Fed has to rejoice in the fact that financial conditions are tightening,” said William Dudley, a former New York Fed president. “They’re making some progress at the moment.” That doesn’t mean the Fed can stop raising rates, but the pressure to raise rates more aggressively than originally planned does ease. Dudley said they still had to deliver on their promises as planned.
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