Economy · July 30, 2022

The strong dollar is a major headache for other countries

American tourists lucky enough to arrive overseas this summer may find themselves pleasantly surprised by the strength of the dollar, up 10% this year against other major currencies. Cheap ice creams are waiting for you on the beach. 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 main driver of the dollar’s strength has been the rise in US interest rates, from around zero at the beginning of the year to between 2.25 and 2.5 percent as of this week. Faster tightening relative to other large economies has fueled a surge in the value of the dollar.

The Federal Reserve’s run for higher rates is well deserved. Over the past 12 months, the US consumer price index has risen by a colossal 9.1%. Jay Powell, Fed chairman, said: “We will focus on lowering inflation. . . It is something . . . we simply have to do. It is too late to stop the large price hike that is now well underway, but not too late to struggle to keep expectations anchored so that inflation returns to the ground.

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

Growing evidence of a slowdown, however, means the point where the Fed should stop hiking may be with us soon enough, but not yet. Rather unusually, the markets also expect the Fed to start cutting rates fairly quickly. In the meantime, however, the gap between rates in the US and the rest of the world is a problem. What is good for the American vacationer, sadly, is not good for the world.

The strong dollar directly affects American trading partners. But one of the peculiarities of the world economy is the extent to which the greenback is used when evaluating goods and services between people who have no connection to the United States: a recent IMF document put it at about 40% of the invoices from a large sample of countries. Food and fuel, the cornerstones of the surge in inflation, are generally quoted in terms of the US currency.

But this is no mere accounting note: The IMF has also found that prices for firms trading 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, even for countries that don’t even trade much with the United States.

The result of these forces is that other central banks may have to act on the strength of the dollar, because a strong dollar closes the price and rises directly in their economies. The Fed remains firmly focused on domestic inflation and there is little appetite for multilateral action. So the only solution for other central banks is likely to be to raise rates a little higher and perhaps a little faster than they would otherwise.

There was some good news from the eurozone this week, with stronger than expected production data. This could make it easier for Europe to cope with further increases. But the global problem of the strong dollar speaks to the extraordinary complexity of this moment for central banks. It is not enough to face the war in Europe, the surge in goods and the aftershocks of an epochal pandemic. Now they have to worry if the people of Washington are accidentally sending more inflation their way, along with American vacationers with big spending.