As US markets were closed to mark the Labor Day holiday, the dollar index surged to a new three-decade high.
This is a reminder that the dollar is a relative, rather than an absolute, price — that is, it measures the value of the dollar relative to other currencies. But this also signals that while the US is likely to outperform other countries in most global macroeconomic scenarios for the year ahead, policy makers and market participants still need to keep a close eye on what’s going on elsewhere in the world, as global events will have a meaningful impact on the overall wellbeing of the US.
On Monday, the DXY dollar index appreciated to a level not seen since 2001. The move was driven by broad-based weakness in other currencies, with particularly notable moves against Sterling (which hit a new record low against the dollar) and the Euro (which traded below 0.99 to the dollar).
The major driver of dollar strength on Monday was yet another disruption to the European gas market as Russia announced an extension to the shutdown of the Nord Stream pipeline. Gas prices opened the European trading session 25% higher than Friday’s before moderating somewhat. With Russia weaponizing gas supplies in reaction to the West restricting its access to the international payments system and formulating energy price caps, a highly damaging total shutdown of supplies in the months ahead has become an alarmingly real, if not highly likely, possibility.
This is coming at a time when Europe has yet to devise an allocation plan to minimize the damage of sky-high energy prices to lives and livelihoods. Though, over the weekend, different countries announced different measures, and others are soon to follow.
The reaction of the dollar index should not be surprising. The European economy’s sensitivity to disruptions in gas supplies is far greater than that of the US, increasing the wedge in likely growth performance. The European Central Bank will face even starker tradeoffs as it seeks to respond to an inflation rate for the euro zone, which, already at 9.1%, stands above that of the US. The same issue is also challenging the Bank of England.
In the old days, there would have been quite a political reaction to a 12-month dollar appreciation of some 20% in the index to a level not seen in decades. Concerns about the US losing international competitiveness would have been accompanied by accusations of unfair currency practices. Not so today, as dollar strength is helping the US combat its immediate problem of high and persistent inflation, which is at 8.5%, according to the last monthly reading of the consumer price index for July.
Although the US may be comforted by the anti-inflationary impact of the surging dollar, it should worry about what the currency’s strength says about the prospects for the rest of the world.
The longer and higher the dollar soars above the rest, the greater the risk of more prolonged global stagflation, debt problems in the developing world, more restrictions on the free flow of goods across borders, greater political turmoil in fragile economies and greater geopolitical conflicts. All of this would affect the US economy sooner or later through some combination of lower demand for its exports, more uncertain supply chains, financial losses and greater national security concerns.
The US cannot do much to directly counter the drivers of currency weakness elsewhere. But it can — and in fact should — do two things in response.
First, it should intensify the domestic policy effort to ensure that the (highly likely) outperformance of the US economy is accompanied by safeguards against disappointing absolute performance. This, most importantly, involves the Federal Reserve battling inflation more effectively, enacting additional pro-growth and pro-productivity structural measures, offering greater protection for the most vulnerable segments of society, and enhancing supervision of non-banks.
Second, the US should lead the way in coordinating with allies on policies to contain the scale and scope of damage to the global economy. There is a fallacy in the current inclination of so many countries to “self-insure” against common global shocks in the absence of proper multilateral cooperation. The more this continues, the greater the overall pressure on everyone.
A strong dollar helps the US to reduce imported inflation, but it is far from a panacea. Too big a currency shock risks undermining and, in some specific aspects, destabilizing a global economy that is yet to fully come to grips with the consequences of declining growth and high inflation.