The Federal Reserve’s focus on taming inflation is inflicting a world of pain on other economies.
The mighty dollar is steamrolling everything right now, causing issues for economies almost everywhere—except in the US. That means that, for now at least, it’s not America’s problem and the historic central-bank-fueled surge in the greenback is unlikely to abate anytime soon.
By some measures the US currency is already stronger than ever, eclipsing the highs of the Covid-19 pandemic from early 2020. The pain it’s inflicting has echoes of the mid-1980s, when foreign exchange chaos forced the world’s most important finance officials to join hands and impose a solution on markets. Right now, though, it’s every country for itself as the US administration pushes back on the idea of coordinated market action.
With the risk of economic damage spreading, officials from Tokyo to Santiago have been drawn into the fray to prop up their currencies with improvised solutions such as selling dollars directly into the market. But Federal Reserve chief Jerome Powell is squarely focused on fighting inflation at home, doubling down on rate-hiking plans that have supercharged the dollar. And US Treasury Secretary Janet Yellen has said she believes financial markets are working as they should.
A combination of alluring interest rates in the US and the comfort of feeling your money is safer in dollar-denominated assets is helping buoy the greenback. In more normal times, officials might welcome a weakening of their currencies, which tends to stimulate growth by making exports more competitive while encouraging consumers and businesses to buy local. But these aren’t normal times. Right now the problem bedeviling officials from Frankfurt to Seoul is high inflation—and weak currencies add fuel to that by increasing the cost of imported products and stimulating domestic growth. So some governments and central banks need to respond to the ongoing battering.
Britain’s pound is just the latest major currency in the spotlight after new government fiscal plans sparked a dramatic loss of confidence in sterling. But it was, like its peers, under tremendous pressure before that, trading near multidecade lows. Elsewhere, the yen has weakened so much that Japan’s government has stepped directly into markets on several occasions since Sept. 22; India, Chile, and others have also felt compelled to intervene. Europe’s common currency, meanwhile, has sunk below parity with the dollar under the weight of the region’s energy crisis.
The currency situation is also forcing central banks around the world to consider ratcheting up their own interest rates further, which risks driving their economies into recession.
“The Fed is aware of the externalities of what they do—because we are the global reserve currency—but they have a domestic mandate and are focused on that,” says Paul McCulley, a former chief economist at Pacific Investment Management Co. who now teaches at Georgetown University. It’s unclear when such externalities might “move from noise to signal for the Fed, effectively coming back and impacting what they are doing,” he says. For now, McCulley sees the world left dancing to the Fed’s hawkish tune and suffering the “pain” that Powell himself has warned will result.
From the Fed’s perspective, a strong dollar actually helps the fight against inflation. By crimping the competitiveness of US business on the international stage, it acts to curb growth, in turn removing some inflationary pressure. This gives officials reason not to pull punches as they press the most aggressive monetary tightening since Paul Volcker wrestled with runaway inflation in the 1980s. The dollar’s strength was also a problem then until the so-called Plaza Accord reined it in. One key difference: The 1985 agreement between the UK, France, West Germany, Japan, and the US came only after Volcker had already broken the back of inflation, whereas the outcome of the present battle is very much undecided.
“Right now, the only mandate that matters to the Fed is controlling inflation,” says Stephen Roach, a Yale University senior fellow and former chairman of Morgan Stanley Asia. Mostly as a result of that single-mindedness, the global economy is heading toward recession, according to Roach. “That will certainly alter the inflationary pressures—and could lead to some stabilization on the other side of that for currency markets—but that’s putting the cart before the horse in this case now,” he says.
Case in point: Atlanta Fed President Raphael Bostic acknowledged concern that the UK’s turmoil could spill over into the US economy because it presents risks to global growth. Still, he refused to dial back his support for further Fed rate hikes.
So long as what’s going on around the globe doesn’t reverberate back into the US economy, the Fed can focus on its immediate task. A key question for Powell and Yellen is whether there will come a point at which international problems can’t be ignored.
The Treasury secretary said Sept. 27 that she thinks “markets are functioning well,” while White House economic adviser Brian Deese was even more explicit in saying that he doesn’t expect another 1985-type agreement among major economies to counter the dollar’s strength. The Fed, too, is staying the course, raising its benchmark rate at its most recent policy decision on Sept. 21 by a further 75 basis points and lifting its forecasts of how high borrowing costs will go. Those moves prompted an historic rout in bond markets that’s pushed the 10-year Treasury yield above 4%, to levels last seen back in 2008.
Despite the unease in markets, the mounting losses in bonds and stock portfolios and tumbling currencies elsewhere are largely in line with what Fed officials are trying to engineer: tighter financial conditions that will help put a lid on inflation. And so far, there are few signs of dramatic market breakdowns like those in previous financial crises. The world’s central banks haven’t had to tap emergency facilities at the Fed, and credit markets show that people remain more than willing to borrow and lend—albeit at a different price.
“The selloff in US bonds and credit within the context of an accelerated Fed rate cycle are not disruptive,” says Alan Ruskin, chief international strategist at Deutsche Bank AG. “That could change, but we are not there yet.”
