While Americans visiting Europe find that their dollars buy less, the recent sharp weakening of the world’s reserve currency is a lot less of a problem for the US and much more for the rest of the world, where it increases already complex economic and policy challenges. It also continues a “hot potato” syndrome that highlights the underlying structural fragility of the global economy, as well as undermining the foundation crucial to solidifying and sustaining elevated asset prices.
Commenting on a dollar that had appreciated by 5 per cent from the time he won the elections to the end of that year, incoming President Donald Trump warned in January that the currency was “too strong” as it hurt the ability of US companies to compete internationally. Since then, the greenback has depreciated steadily, touching a 33-month low during Friday’s trading session in what amounts to a 9 per cent decline in the trade-weighted index so far in 2017. It has been a broad-based move against the currencies of both advanced and emerging economies, even some that maintain managed pegs with longstanding ties to the dollar, including China’s, which in the last few days, however, has started to resist.
The primary driver of the dollar’s decline has been a narrowing of the differential in market expectations for economic growth and monetary policy. During the past few months, actual and expected growth has picked up in Europe and Asia, both in absolute terms and relative to the US.
Concurrently, with the implied market probability of a December hike having fallen sharply (to below 30 per cent), traders have aggressively pushed back to June of next year material expectations of the next Federal Reserve hike — this at a time when they have also been internalising signals from the European Central Bank that it may move as soon as next month in announcing plans to reduce large-scale asset purchases.
While some segments of American households and companies will suffer from the recent depreciation, the overall economic impact is likely to be favourable. By enhancing price competitiveness, it provides a tailwind for economic activity and job creation. It is supportive of financial markets, given that companies in the S&P 500 derive a significant portion of their revenues from abroad.
Also, at the margin, it increases the chances of the Fed progressing with its “beautiful normalisation” after an unexpectedly prolonged reliance on experimental unconventional measures — that is, restoring policy rates and the balance sheet to less extreme and less distortive levels without derailing growth and causing financial instability.
The picture is less rosy for the rest of the world. Most economies now have to contend with a stronger headwind to growth and, in the case of Europe, downward pressures on an inflation rate that the central bank worries is already too low. With continued delays in implementing the much-needed set of pro-growth policies, this serves to weaken the cyclical growth impetus and amplify the effects of structural impediments to higher and more inclusive growth.
The dollar’s round-trip over the past 10 months also brings into sharper focus an important dimension of today’s currency markets. With limited exceptions, such as Germany, there are very few countries able to absorb and navigate easily a sustained period of sharp dollar appreciation — and this for a simple reason: compensating growth engines are still too weak. As such, rather than be part of an orderly growth-enhancing global rebalancing, currency moves nowadays involve too many zero-sum elements that can also fuel economic nationalism.
John Connally, when Treasury secretary in President Richard Nixon’s cabinet, famously told his European counterparts in 1971 that the dollar “is our currency but your problem”. With the structural fragility of today’s global economy, and with continued overreliance on monetary policy, this dictum could easily be generalised to many currencies experiencing a sharp depreciation.
Until this situation is resolved through more comprehensive and better co-ordinated policy responses, currency markets will pose a threat to the solidification of a synchronised global recovery needed to validate stock prices around the world in a durable manner.
Mohamed El-Erian is chief economic adviser to Allianz and author of the book “The Only Game in Town”