Chapter 7. The dollar is up, food prices are up and ‘you should see the other guy’

We’re gonna discuss the strength of the dollar and also its weakness. Everything that’s very good also is a little bad, and vice versa

The dollar (.DXY) is measured on an index against a basket of six major currencies. In 2021 it gained nearly 7% against major currencies and in 2022, 4 months in, it has gained another 5%.

Currencies are traded on the foreign exchange (“FOREX”) market.

Most countries, like the U.S have a flexible exchange rate and allow FOREX trading to determine the value of their currencies. It is floating and the market decides the price

Alternatively, many countries will use a “dollar peg”. This is when a country maintains its currency’s value at a fixed exchange rate to the U.S. dollar. The country’s central bank controls the value of its currency so that it rises and falls along with the dollar. 

• 66 countries either peg their currency to the dollar or use the dollar as their legal tender
• 25 countries peg their currency to the euro and the 19 eurozone members use it as their currency
• Many countries also have hybrids currency models, dual currencies and other mischievous ways of ‘money stuff’ 

The value of one currency against another is in large part a function of central bank policies in each country.

• If a central bank pursues loose policy — low interest rates that increase the risk of inflation — a currency will fall in value relative to the currencies of its trading partners.
• When a central bank tightens policy — raises interest rates — then the currency generally strengthens.

One reason for the dollar’s strength lately is the expectation that the U.S. Federal Reserve will begin raising interest rates fairly soon as the U.S. economic recovery gains. Then question then becomes: How will a stronger dollar affect America’s economy?

The rest of the World

For the most part the devastating inflation that is ravaging much of the world has a more muted affect here, at least so far. Gas prices are high, but they are higher ‘over there’, same with food prices and so on.

A high value of the dollar is a massive tax on U.S. exports and a huge subsidy to U.S. imports. It’s a big bounty for foreign countries to dump their products on U.S markets at deep artificial discounts. Although there are many reasons for the dollar’s recent rise we should get some context by going backwards because the past is happening again.

In the late 1990s the United States was booming, inflation was low and economic growth was high. At the same time Japan had continuing stagnation, continental Europe had slow growth and high unemployment, the Asian financial crisis was ripping, and there were financial turmoils in other countries from Russia to Argentina. All this led to a massive flight of capital funds out of those countries and into the one “safe haven” in the global economy: the United States. 

Let’s look at some of that in greater detail,  the overall impact of U.S. economic strength relative to foreign economic weakness.

Japan…

Intervened, both in its own central bank operations and in concert with other exporting countries that relied on currency warfare, to halt the dollar’s previous decline by increasing their purchases of U.S. government securities, propping up the value of the dollar and preventing their own currencies from appreciating further, they made the japanese Yen less appealing to invoice in and to hold in central banks. 

It was these interventions that effectively started the dollar on a new, never ending upward course and contributed significantly to rising U.S. trade deficits at that time. It’s never looked back, the trade deficits keep on growing.

Foreign countries’ fiscal policy decisions were to block exchange rate adjustments and preserve their protectionist trade policies and the reliance on export-led growth.

The rise, and the role of the US dollar was not in itself due to any “strong dollar” policy. The US has little meaningful exchange rate policy and cannot implement one given an independent Federal Reserve targeting inflation. The ability of policymakers to set an exchange rate independently of market forces for extended periods of time is limited. To accommodate short term dollar movements, the Treasury can intervene in foreign exchange markets and weaken the currency.

Its main tool is the Exchange Stabilization Fund, which is operated by the Treasury which can use the fund’s assets to buy foreign currencies in the open market, boosting their value against the dollar.

The Fed has traditionally matched Treasury intervention funds, thus doubling the Treasury’s firepower. In principle, the Fed could also expand its balance sheet beyond that to buy foreign assets, and other countries could agree to join the United States in an intervention to lower the dollar.

One way to conceptually understand one result of an asymmetrical currency war is that these countries effectively exported unemployment to the U.S. 

A higher dollar brings down import prices and forces domestic firms that compete with imports to either cut price-cost margins and/or lose sales volume.

• There are indirect effects of dollar appreciation on investment through the reduced profits of domestic manufacturing firms. Business firms rely on the cash flow out of current profits to finance investment, either internally (through retained earnings) or by attracting outside funds. Reduced profits curtail the ability of firms to finance their investment and can result in the cancellation or delay of already planned capital expenditures.

Let’s move to the other side of the dollar.

Depreciation of Emerging Market currencies against the US dollar raises that burden associated with a higher share of foreign-currency-denominated debt obligations, this frequently leads to a dollar denomimated debt crunch, countries and businesses have to repay loans, but their currencies have gone down in value and the US dollar has gone up.

Most emerging market currencies are being hammered against the dollar, and it’s going to be more hammering as the Federal Reserve finally delivers expected aggressive policy “tightening”

Food and Stuffs

Consumers in emerging market countries will suffer more pronounced effects of inflation and food scarcity as they experience even higher increases due to the higher dependency on food imports, already a crisis in countries in sub-Saharan Africa, the Middle East and North Africa.

Emerging markets and low-income countries are also more vulnerable to food price shocks because consumers in these countries spend a relatively large proportion of their income on food.

While their people are starving, the currency depreciation against the US dollar is made worse by falling export and tourism revenues and net capital outflows. 

Back in America

The dollar being high can be good for short durations to allow Americans to smooth economic shocks that can have enormous ripples, however this has been a 40 year assault to make the dollar high. Short term good, but long term bad. it will help us dampen the effects of inflation, but it’s not free.

And so on