Across the world, the rise in the dollar is hurting economies, disrupting financial markets and leaving destruction in its wake. Some central banks are now pulling back.
On Friday, the People’s Bank of China became the latest central bank to intervene, trying to slow the pace of the renminbi’s depreciation against the dollar. A week earlier, the Japanese Ministry of Finance began to intervene. The Reserve Bank of India has attempted to slow the rupee’s depreciation and the Bank of England has been forced to warn of impending monster rate hikes after sterling fell to a multi-year low.
Which may sound strange to some. After all, countries like China have been accused in the past of artificially preventing their currencies from appreciating. In fact, governments often like weaker currencies. It makes exports more attractive, attracts more foreign tourists, and can be a relatively inexpensive way to increase a nation’s competitiveness.
However, only up to a certain point and as long as the movement is contained. And the dollar rally of 2022 was anything but. The resulting runaway currency weakness elsewhere can lead to both capital flight and future inflation as imports become more expensive, forcing central banks to tighten monetary policy more than planned.
No wonder, then, that rumors are circulating of a new “Plaza Accord,” à la the 1985 accord between the world’s major economies, to bring about a significant devaluation of the US dollar to mitigate the negative impact on many other countries.
More recently, in February 2016, we saw a so-called “Shanghai deal” after the dollar took a massive run that eventually sparked months of capital flight from China, threatening global growth and financial stability.
Although no official pact was announced, unlike in 1985, the Fed quietly slowed down its cycle of rate hikes. In December 2015, the Fed’s “dot plot” promised four quarter-point hikes in 2016. Instead, the Fed waited until the end of the year and hiked only once. The greenback began to weaken from late February and financial markets, which had had a terrible start to 2016, calmed down.
We’ve been inundated with questions from customers over the past few days as to whether a repeat is now likely. With global policymakers gathering for the IMF meeting in Washington, DC in mid-October, surely a new Plaza deal is around the corner? Yes, the most important step for any new dollar deal is for the Fed to halt its planned rate hikes. Nothing works without that. But given the damage a strong dollar is now doing elsewhere, surely Fed officials are ready?
No chance. Like Tom Petty, the Fed will not budge.
First, while dollar strength may result in higher inflation in other economies, it does not result in much lower inflation in the US. Since many of the world’s goods and services are denominated in dollars, US import prices fall much less than would be expected if the dollar strengthened. Additionally, the US is a fairly inward-looking economy; Trade and its associated price implications are almost never a sufficiently important factor in the macroeconomic outlook.
And most importantly, the US economy is still far too strong for the Fed to change course just for the good of the rest of the world. This is not 2016, when US inflation was below 2 percent for most of the year. With inflation at 8-8.5 percent for much of this year, the Fed simply has no room to retreat.
And while there are signs the rest of the world is suffering, consider the recent set of US data. PCE core inflation is close to 5 percent and the latest report was stronger than consensus. The personal consumption and spending releases a few days ago surprised to the upside.
Yes, housing is struggling, but the Fed has waved that away and has focused almost exclusively on the red-hot job market, which is still generating nearly 400,000 jobs a month as of late.
There are also no signs that the labor market is slowing down much. While it’s been four weeks since the last jobs report, initial jobless claims have been falling for the past few weeks and remain remarkably low. And with no sign of a turnaround, the Fed will stay the course. The dot plot signaled another rate hike of 75 basis points in October and another 50 basis points in December and it’s hard to imagine them changing their minds over economic troubles outside the US.
And no one can accuse them of hiding their intentions. Even as UK financial markets experienced unprecedented volatility last week, Fed spokesman after Fed spokesman continued to adopt a hawkish tone.
Fed Vice Chairman Lael Brainard warned of the dangers of pulling back from hikes too soon. San Francisco President Mary Daly, often referred to as the dove, stressed that fighting inflation is the Fed’s top priority right now. St. Louis Fed’s James Bullard downplayed the impact of dollar strength. Even more emphatic was Loretta Mester, President of the Cleveland Fed, who said that even a recession would not stop the Fed from restoring price stability.
These are hawkish words – and they suggest that no matter how much stronger the dollar gets in the near term, there is no reversal in policy in sight.
Over the next few weeks, many of the world’s policymakers will no doubt be flying to DC asking for a breather. But the Fed will be sympathetic but unmoved. All we can say to anyone hoping for a new Plaza Accord is good luck.
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