Despite the Extensive Damage, Why Does the US Support the Strong Dollar Policy?

In the midst of a trade war and a power struggle between the two countries, the United States ago accused China three years of manipulating its currency exchange rate to boost the growth of its economy. However, with the succession of global health, security, and energy crises in the next stage, the United States became the accused.

Despite China and the United States agreeing to deny adopting this approach, declaring their commitment to the values of the free circulation of currencies and the exchange rate determined by the market, they differ in the nature of their goals.

While Beijing was trying to overcome US tariffs imposed on it in mid-2019 under former President Donald Trump, Washington is currently fighting a war against the high rates of inflation, which it considers to come from abroad and does not reflect the nature of the domestic economic activity.

But the interesting thing is that many observers question the feasibility of the US approach of tightening monetary policy through the continuous raising of interest rates in order to curb inflation.

They believe that the strong dollar resulting from this policy will cause greater damage to the American and global economy and ignite a currency war worldwide.

 

Inflation Fire

The US Department of Labor revealed on July 13, 2022, that the Consumer Price Index (inflation) rose in the previous month by 9.1 percent on an annual basis in broad progress, confirming that it was the largest increase since the end of 1981.

US inflation accelerated in June more than expected, prompting many economic circles to stress that continued price pressures will keep the Federal Reserve on the path of raising interest rates, which means strengthening the dollar price.

The next day, Bloomberg revealed, the dollar index rose to an all-time high. Investors also boosted bets on a rate hike by the Federal Reserve later in July.

The Bloomberg Spot Dollar Index, which measures the US currency against a basket of developed and emerging market currencies, rose 1.2 percent to 1,304.55 points, driven by a combination of interest rate hikes, growing demand for the currency as a safe haven, and recession fears.

On the same day, the exchange rate of several major currencies deteriorated against the dollar, led by the euro, which was equal to the dollar for the first time in more than two decades after the European currency suffered a rapid and significant decline of about 12 percent in the first half of 2022.

This came as a result of multiple pressures, especially the Russian war in Ukraine, which compounded the effects of the energy crisis caused by the Corona pandemic, as well as the growing risks that Moscow could cut off gas exports, bringing the Eurozone closer to recession.

On his part, Federal Reserve Chairman Jerome Powell confirmed, on June 22, 2022, that the central bank will continue to raise interest rates to tame inflation, recognizing that a recession in the United States is likely.

The Federal Reserve raised interest rates by 75 basis points in June, the largest increase since 1994, to reach the target range of 1.5 to 1.75 percent. Powell confirmed that they would likely do the same again during July.

In his semi-annual testimony to the Senate Banking Committee, Powell said: "The upward trend in inflation has clearly been surprising, and there could be more surprises. So we will need to be smart in responding to incoming data and evolving forecasts."

"Fed officials agree that the need to raise interest rates may continue for a longer period to prevent high inflation from taking hold, even if it slows the US economy," he added.

 

Global Annoyance

This tight monetary policy greatly disturbs emerging and developed markets because it increases borrowing costs and fuels financial market volatility, and paves the way for a counter-currency war by also raising interest rates in those countries in order to maintain the price position.

In the last three months, India, Malaysia, Switzerland, and Britain suddenly raised interest rates, and New Delhi and Hong Kong also intervened to support the exchange rate.

The New York Times pointed to this scene during an analysis published on July 16, stressing that "the value of the US dollar is the strongest it has been in a generation, devaluing currencies around the world and unsettling the outlook for the global economy, because it flips everything from the cost of vacations abroad to the profitability of multinational companies."

"As a result of the Fed's moves more quickly and forcefully than most central banks around the world, the Japanese yen fell to its lowest level in 24 years against the dollar, and the euro fell to its parity level for the first time since 2002," it added.

The Colombian peso, the Indian rupee, the Polish zloty, and the South African rand have also lost a lot of value against the dollar, especially in the last six months.

The issue of the dollar's growing strength was raised at the G7 finance ministers meeting on May 18, 2022, in Bonn, Germany.

In response to questions about the dollar's continued rise, US Treasury Secretary Janet Yellen claimed that "the United States is committed to a market-determined exchange rate."

"The tightening of US monetary policy and investors' aversion to risk are factors in the interest of the dollar, but the best way is to have an exchange rate determined by the market," Yellen added.

"The dollar is a global safe haven. We are witnessing capital flows, and it is natural for the US currency to rise in times of increased economic uncertainty. Therefore I think that its rise is something that is understandable," she said.

However, these statements did not convince many economic analysts who started talking about the possibility of the major countries agreeing to manipulate the exchange rate in order for the United States to reverse its policy, as happened in the Plaza Accord in 1985.

This agreement was intended for the governments of France, West Germany, Japan, and Britain to intervene to change the policy of raising US interest rates (at that time, it reached 20 percent), which caused the dollar to strengthen significantly in order to reduce inflation during the era of US President Ronald Reagan.

The four countries agreed with the United States to reduce the value of the dollar against the Japanese yen and the German mark by intervening in the currency exchange markets on September 22, 1985, at the Plaza Hotel in New York City.

 

Counter Campaign

In this context, economist Stephen Miller says that the current situation raises memories of the Plaza Agreement, a position taken on the basis of the belief that the massive rise in the dollar's valuation will harm the global economy, according to Bloomberg.

"Perhaps one of the advanced options would be to have some kind of coordinated intervention between states in the style of the Plaza Accord. Markets understand that central banks are in a difficult situation when they only have one means of influence, and that is the interest rates they are raising," Miller added on May 19.

Nevertheless, Miller ruled out any imminent intervention during the current stage or in the near term because a stronger dollar leaves imports less expensive for the US, an attractive advantage during an era of high inflation.

However, Deutsche Bank's Co-head of FX Strategy, Alan Ruskin, said, "if the euro exchange rate fell below 0.90, against the dollar, this might set off alarm bells."

In turn, Goldman Sachs analyst Zach Pandl said that "the turbulent rise in the dollar's exchange rate may be a change in the rules of the game."

"China's rise in global markets is another influential factor, as Beijing will likely need to agree to any coordinated move implemented by central banks. However, the yuan is not trading at levels that need such intervention at the moment," he added.

On her part, British expert Jane Foley expressed her surprise that Washington would do something against its interests, asking: "Why would the Federal Reserve tighten financial conditions on the one hand and then reduce them on the other hand by intervening against the dollar?"

However, this reluctance may change if the US economy contracts and the strength of the dollar cause sectors such as employment and trade to falter, with the probability of a recession in 2023 more than 30%, according to a Bloomberg survey on May 19.

On July 13, Bank of America Corp. economists forecast a mild recession this year in the United States, noting that spending on services is slowing and that high inflation is motivating consumers to cut back on spending.

The bank expected that the gross domestic product in the United States will decline during the fourth quarter by 1.4 percent on an annual basis, to be followed by an increase of 1 percent in 2023, which could raise the unemployment rate by 1 percentage point to about 4.6 percent.

 

Double-Edged Sword

Despite the fact that the dollar's rapid rise since the beginning of the year is considered by many experts as a double-edged sword, as it brings benefits and harms to the US economy, others assert that for the moment, it is still very much in the US interest, so it continues to adopt this approach.

International experts assert that modern economic history is replete with countries exploiting the exchange rate of their currencies to extract greater investments in their bonds from other countries.

The current strong dollar policy is based on exploiting weaknesses in other countries to make changes in their exchange rates against their local currency and to force adjustments by their governments and central banks in favor of the dollar.

This is evident when looking at the economic scene now, as the growth of the Chinese economy slowed sharply in the second quarter of 2022 as a result of the huge losses caused by the large-scale closures due to the outbreak of the Coronavirus, something that indicates pressure that will continue over the coming months.

The Wall Street Journal confirmed on July 11 that "China's Covid-19 cases are rising at the fastest pace since late May, unnerving investors wary of a repeat of Shanghai's two-month lockdown, which snarled global supply chains."

On the same day, the New York Times said that China's strategy to eliminate the disease comes with economic and social consequences and leads to the closure of apartment complexes, neighborhoods, or even entire cities for days or weeks, to get rid of some cases.

The European Union is also going through dangerous security and economic curve in light of the sudden change in its policies after the Russian invasion of Ukraine and its quest to stop its heavy dependence on Russian energy imports, which makes it in a phase of weakness that brings it closer to recession.

As for the United States, American officials in both the Democratic and Republican parties assert that the current spiraling inflation is due to external factors, including energy, food, and supply chain crises and the Chinese shutdowns, so they support the strong dollar policy.