Dollar at a Crossroads
May 24, 2022
In contrast to the past year of methodical appreciation, one can conjure up vastly divergent dollar performances over the year ahead. From lows in May 2021 to highs earlier this month, the U.S. currency climbed about 17% in weighted terms, 23.7% against the Japanese yen, 18.5% versus the euro and 17.2% relative to sterling. Many of the economic pillars usually associated with currency weakness were paradoxically present. With hindsight, the policy of the Federal Reserve was way too loose, although that behind-the-curve status wasn’t widely apparent as it played out in real time. Inflation accelerated at a speed and to levels not seen in decades. The labor market became very tight, and America’s trade deficit widened over 40% to $288.8 billion last quarter from $204.1 billion in 1Q 2021.
The dollar has fallen somewhat below highs reached earlier this month, but the magnitude of what’s been given back pales in comparison to other financial moves such as the drops of 19% in the S&P 500 and 30.8% in the Nasdaq. Investors are anxious about future monetary policy, which if to be successful will need to tighten more aggressively than the economy can comfortably process. A progressively forceful withdrawal of monetary stimulus with a deaf ear to the drag on real demand and production will be required. Because inflation a year ago ran hot, year-on-year comparisons should improve, but that desired result will be blunted by headwinds such as continuing supply disruptions and higher inflation expectations.
Meanwhile, fiscal policy will not be available as a counterbalance to the drag of monetary policy. The dollar enjoyed a multi-year period of strong demand in the early 1980’s not only because of the Federal Reserve’s very tight monetary policy and receding inflation, but also because of an expansionary fiscal policy that contributed to the rise then of U.S. real interest rates and made the period politically tolerable. Fiscal policy in the year ahead will support GDP growth to a considerably less extent than in the past year. As it is, the 3.6% year-on-year rise of U.S. real GDP between 1Q 2021 and 1Q 2022 was less than concurrent expansions of 8.7% in the British economy and 5.1% in the euro area. By comparison and to add some historical perspective, U.S. GDP growth from 2004 through 2013 averaged about twice the pace of growth in the euro area and Japan and 50% more than growth in Great Britain.
Relatively strong U.S. growth is a condition that holders of dollar-denominated wealth would welcome, but such does not by itself guarantee a well-bid currency. It is often overlooked in the often-maligned narrative of the U.S. economy during the Carter presidential years that U.S. real GDP on average advanced 3.8% per anum between the last quarters of 1976 and 1980. That’s a pace that ranks high among all post-WW2 presidencies.
Even if U.S. inflation remains well above its 2% target in the year ahead and the economy comes close to stalling, the dollar could do fine if investors become more confident in the Fed’s stance and believe in the likelihood of a return to sustained price stability. One of the big takeaways from America’s frustrating experience with inflation from the mid-1960s through 1980 was the Fed’s unfortunate propensity to end restraint prematurely. That produced a see-sawing trend of higher lows and higher highs over ensuing inflationary cycles in the period. The dollar should enjoy a safety net if the Fed doesn’t repeat that mistake, inflation slowly retreats, and real and inflation-adjusted yield premiums become more attractive.
There is one more big if that needs to evolve in a supportive way, and that involves intangibles like the yawning political gap in America, the war between Russia and Ukraine, and relations between Washington and Beijing. American democracy and its political stability grounded in the rule of law rather that people were essential prerequisites for the dollar-centric international monetary system that emerged after World War II. Those properties have greatly unraveled, and November’s election may push matters to a point of no return. Separately, one can only hope that President Putin finds a way to defuse his war without imperiling world peace. And President Biden’s trip this week to Asia has underscored the importance yet unpredictability of the relationship between Washington and Beijing to the dollar’s prognosis.
Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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