The Plaza Hotel in New York is best known in financial circles for when the finance ministers of France, Japan, the United Kingdom, the United States and West Germany met met in 1985 to suspend the free float of the US dollar.
The problem the ministers sought to solve was that the US dollar had risen 44% since 1980 because US interest rates had jumped during that period. The world feared that the subsequent widening of the US trade deficit would prompt Washington to restrict imports. As part of the Plaza Accord, the G-5 agreed – and did – to lower the US dollar over the next two years.
Another Plaza Accord may be needed in the future. Once again, rising interest rates in the United States are pushing the US dollar to heights that are confusing the world. Against the “broad real dollar index”, the US currency has jumped 10% over the past year to its highest level since this index was compiled in 2006. US interest rates rise because the Federal Reserve must stifle inflation which has reached four-decade highs.
U.S. dollar broad nominal index since 2006
Higher interest rates in the world’s largest economy still present challenges for the world. Today’s hardship from higher US interest rates, however, could be more troubling than usual, as the pandemic and war in Ukraine amplify the standard threats posed by higher US interest rates while minimizing the usual benefits. Three difficulties stand out, starting with the rise in the greenback.
While a stronger U.S. dollar eases U.S. inflationary pressures via cheaper imports, the flip side is that the rest of the world faces an inflationary shock in three ways:
- First, US exports cost more in other currencies.
- Second, exchanges valued in US dollars between non-US parties become more expensive in other currencies.
- The third inflationary threat is that the strength of the US dollar today unusually coincides with higher oil prices due to the war in Ukraine, which amplifies the rise in oil prices in other currencies.
To counter this inflationary threat, central banks around the world are unexpectedly raising policy rates in larger steps to prop up their currencies in what has been dubbed a “reverse currency war.” The futility is that not all countries can push their currencies in the same direction at the same time.
The euro zone is particularly vulnerable to imported inflation – the euro has slipped to its lowest level in 20 years (below parity) against the US dollar. Eurozone inflation at a record high belatedly forced the European Central Bank to end eight years of negative rates.
While the ECB’s delay in raising rates has undermined the Euro, the currency’s delay and fall is more due to weak economic fundamentals in the Eurozone. The ECB fears that inflation could push the sovereign debt yields of indebted members of the euro zone to levels that would trigger a new financial crisis and possible exits from the common currency.
A second challenge of higher US rates is that they hamper the US economy. US GDP, which accounts for around 70% of consumer spending, contracted in the first six months of 2022. The immediate outlook looks problematic as pandemic-related fiscal stimulus and supply disruptions have drives up inflation to levels that are worrying consumers. A weak US economy means the high US dollar is not providing its usual boost to global exports – as it did in the first half of the 1980s.
The third challenge of higher US interest rates is that they bludgeon emerging countries, especially those that have borrowed in US currency or whose currencies are pegged to the greenback. The 40 countries most at risk in the world according to IMF calculations have been weakened by the pandemic and face a cost of living crisis resulting from the war in Ukraine. The fact that emerging countries borrow massively in local currencies does not protect them from higher US interest rates and a stronger US dollar. A July article from the Bank for International Settlements warns that currency risk has only shifted to creditors who invest in US dollars. Thus, capital is still fleeing emerging countries.
The Institute of International Finance estimates that international investors withdrew US$38 billion from emerging markets in the five months to July. The currencies of emerging countries fell accordingly. The threat of inflation forced central banks to raise rates to support currencies. There are growing fears that economic turmoil could lead to political instability.
Central banks are far from having won their battle against inflation. The accelerated loop triggered by a world distorted by the pandemic and war, in which higher US rates force other countries to raise rates, could still go on for some time yet. The best hope for the world is that something – ideally, lower US inflation, but even a US recession – will dampen US interest rates and avert financial turmoil in the eurozone and emerging countries.
Granted, US inflation may have already peaked and the Fed could slow rate hikes. But the peak of inflation may matter less than the stubbornness of inflation. If US inflation only slows gradually, US interest rates will remain high.
Too bad that in a world of floating exchange rates, central banks outside the United States, for all their domestic political independence, are tied to a Fed that misjudged inflation. There is no solution, much less an international agreement, shaping to mitigate the dangers.
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