Plastic letters reading “Inflation” are placed on the US dollar bill in this June 12, 2022 illustration. REUTERS/Dado Ruvic/Illustration
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ORLANDO, Fla., Aug 24 (Reuters) – The dollar is rising against the world’s major currencies, heading for its biggest calendar-year rise in almost 40 years and the third-biggest since President Richard Nixon took the dollar off the gold standard more than half a century ago .
Will the Fed be worried? Not a little.
But on the contrary. All else being equal, dollar strength will help ease price pressures by lowering import costs and tightening financial conditions, both desired goals for Jerome Powell and his colleagues as they attempt to rein in 40-year-high inflation target of 2%.
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Minutes from the Fed’s July 26-27 monetary policy meeting — at which it raised the federal funds rate by 75 basis points for the second straight month — show policymakers considered the stronger dollar’s drag on import prices to be one of a few cited factors likely to bring inflation back under control.
There is a growing debate about the dollar’s impact on US inflation in the post-pandemic world. But the Federal Reserve would much rather have the exchange rate appreciate than not.
“The Fed will be inclined to let it run, there is no incentive to stop it. The dollar appreciation isn’t hurting, if anything, it’s helping their case,” said Brad Bechtel, global head of FX at Jefferies in New York.
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The dollar is hovering around a 20-year high against a basket of major currencies. It’s up 13.5% so far this year — on track for its biggest calendar-year rise since 1984 and third-biggest since the dollar’s gold-in-gold convertibility ended in 1971.
On an annualized basis, which is more commonly factored into inflation measures, the dollar is up about 17% this year. This is the biggest disinflationary impulse since 2015, and many believe it will only increase due to interest rate differentials.
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Unlike the central banks in Japan and China, the Fed is determined to hike rates even further. The People’s Bank of China is now going in the opposite direction.
In addition, markets are betting that the US economy will be in better shape this coming winter than its energy-stricken UK and eurozone counterparts. And if there is a global recession, safe-haven demand for foreign government bonds could put natural supply below the dollar.
INDIRECT BENEFITS
According to Jefferies’ Bechtel, the previous rule of thumb was that a 10% rise in the dollar was equivalent to tightening interest rates by around 75 basis points.
Economists at Societe Generale estimate that a 10% appreciation in the US dollar will cause US consumer inflation to fall by 0.5 percentage point in a year.
A Kansas City Fed newspaper published Aug. 17 noted that dollar strength has had a fairly limited impact on consumer prices, at least so far.
They estimate that the 8.5% appreciation in the broad dollar since May last year has reduced annual PCE core inflation by about 0.2 percentage point. A further 5% appreciation by the end of next year will increase this resistance to 0.33 percentage points.
That’s pretty mild.
“A much larger appreciation would be needed to significantly dampen domestic inflation,” the authors wrote in the paper, entitled “Recent US Dollar Appreciation May Not Have Large Impact on Domestic Inflation.”
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The paper notes that the inflation-dampening forces of a strong dollar may be more muted today than in previous years, reflecting pandemic-related distortions in US import demand and disrupted supply. https://bit.ly/3ci2l8L
If Fed policymakers share this view, there is some evidence that they are perfectly comfortable with the current exchange rate and do not mind if it continues to strengthen.
As long as the pace of appreciation is not too rapid to trigger broader dislocations in financial markets, they might well welcome it.
“The stronger dollar is a positive side effect of Fed policy and thus an indirect benefit for the Fed,” said John Silvia, economist and founder of Dynamic Economic Strategy.
There are signs that the dollar’s recent surge is being felt in financial markets. Goldman Sachs’ US Financial Conditions Index (FCI) rose 25.5 basis points to 99.30 last week. The largest single component, 10.2 basis points, retreated from the dollar, the bank said.
This reversed about a third of the FCI’s easing of financial conditions since June, which was driven by the rebound in equity and credit markets, despite the Fed spurring two 75 basis point rate hikes.
Music to the Fed’s ears, but they will almost certainly want to hear more.
(The opinions expressed here are those of the author, a columnist for Reuters.)
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By Jamie McGeever
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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias under the Trust Principles.
Jamie McGeever
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