Across the world, the dollar’s surge is hurting economies, roiling financial markets, and leaving destruction in its wake. Some central banks now are pushing back.
On Friday, the People’s Bank of China became the latest central bank to intervene, trying to slow down the pace of renminbi depreciation against the dollar. The Japanese finance ministry started intervening a week before that. The Reserve Bank of India has tried to slow the rupee’s depreciation, and the Bank of England has been forced to hint of monster rate hikes to come after sterling fell to multi-decade lows.
Which might sound strange to some. After all, countries such as China have in the past been accused of artificially preventing their currencies from getting stronger. Indeed, governments often like weaker currencies. It makes exports more attractive, brings in more foreign tourists, and can be a relatively low-cost way to boost a nation’s competitiveness.
Yet only up to a point, and as long as the move is contained. And the dollar rally of 2022 has been 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 more than they planned to.
Little wonder, then, that rumours are flying thick and fast of a new “Plaza Accord”, à la the 1985 agreement between the world’s major economies to engineer a significant depreciation of the US dollar to temper the adverse impact on many other countries.
More recently, in February 2016 we saw a so-called “Shanghai accord’”, after the dollar had gone on a massive run that eventually sparked months and months of capital flight out of China and threatened global growth and financial stability.
While no official pact was announced — unlike in 1985 — the Fed quietly backed off its hiking cycle. In December 2015, the Fed’s “dot-plot” had promised four quarter-point hikes in 2016. Instead, the Fed waited until the end of the year and hiked just once. The greenback started to weaken from late February, and financial markets, which had an awful start to 2016, calmed down.
We have been inundated in recent days with questions from clients asking if a repeat is now likely. With global policymakers meeting in mid-October for the IMF meetings in Washington, DC, surely a new Plaza accord is around the corner? Yes, the most important step for any new dollar accord is for the Fed to stop its planned hikes. Without that, nothing will work. But surely Fed officials are willing, given the damage that a strong dollar is now causing elsewhere?
Not a chance. Like Tom Petty, the Fed won’t back down.
First, while dollar strength can lead to higher inflation in other economies, it doesn’t lead to much lower inflation in the US. Because many of the world’s goods and services are denominated in dollars, prices of US imports drop far less than one would think when the dollar strengthens. Moreover, the US is a fairly inward-looking economy; trade and the related price impact is almost never an important enough factor to the macro outlook.
And most important, the US economy is still way too strong for the Fed to change course just for the sake of the rest of the world. This is not 2016, when US inflation ran below 2 per cent for most of the year. With inflation at 8-8.5 per cent for much of this year, the Fed simply has no room to back off.
And while there are signs that the rest of the world is hurting, consider the recent run of US data. Core PCE inflation is near 5 per cent, and the latest report was stronger than consensus. 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 focused almost exclusively on the red-hot labour market, which is still creating almost 400,000 jobs a month lately.
Nor are there signs that the labour market is slowing down sharply. While the last jobs report was four weeks ago, initial jobless claims have been falling for several weeks now and remain remarkably low. And without evidence of a turn, the Fed is going to stick to its path. The dot-plot signalled another 75 basis point rate increase in October and another 50bp in December, and it’s hard to see them changing their mind because of economic difficulties outside the US.
And no one can accuse them of hiding their intentions. Even as the UK financial markets saw unprecedented volatility last week, Fed speaker after Fed speaker sounded a hawkish tone.
Fed vice chair Lael Brainard warned of the dangers of pulling back too early from hikes. San Francisco president Mary Daly, often thought of as a dove, emphasised that battling inflation was the Fed’s first priority right now. The St Louis Fed’s James Bullard played down the impact of dollar strength. Even more emphatic was Cleveland Fed president Loretta Mester, who said that even a recession wouldn’t stop the Fed from hiking to restore price stability.
These are fighting words — and they suggest a U-turn on policy is not in the cards, no matter how much stronger the dollar gets in the near term.
Over the next few weeks, many of the world’s policymakers will no doubt fly to DC and plead for a respite. But the Fed will be sympathetic but unmoved. To all those hoping for a new Plaza Accord, all we can say is — good luck.