This blog post accompanies the SDPB Monday Macro segment that airs on Monday, September 19, 2022. Click here to listen to the segment, which begins at minute 23:45.
Yesterday, in an extended exposé, the Wall Street Journal reported the “Dollar’s Rise Spells Trouble for Global Economies.” In the article, the authors describe the current strength of the US dollar as a “once-in-a-generation rally, a surge that threatens to exacerbate a slowdown in growth and amplify inflation headaches for global central banks.” The authors rightly explain the collateral damage that the dollar’s strength imposes on economies around the world; damage that is perhaps greatest in emerging-market economies that can least afford it. In those economies, the dollar’s strength is particularly great, as is the relative share of debt that is denominated in dollars; thus, the strength of the dollar imposes a greater debt burden on those who owe dollar-denominated debt. Meanwhile, negative implications for other economies, including some of the world’s most established economies in Asia and Europe, abound. So whom do we blame for this international macroeconomic fallout of a strong dollar, and why?
Blame the Fed…for doing the right thing.
But first, some background on foreign exchange and the theory of so-called interest-rate parity.
A foreign-exchange rate—hereafter, an exchange rate—is the price of one currency in terms of another. For example, around the time this blog post published, the price of a US dollar in terms of the British pound was £0.87 per US dollar; or, put differently, the price of a British pound in terms of the US dollar was $1.15. Quoting either relative price— £0.87 per US dollar or $1.15 per British pound—is correct, of course. To be consistent throughout this blogpost, I quote the exchange rate as the foreign-currency price of the domestic currency: for example, I use £0.87 per US dollar as opposed to $1.15 per British pound.
The pound price of a dollar is determined by the demand and supply for each currency in the wholesale foreign-exchange market, where financial institutions buy and sell currencies—or, more precisely, bank accounts denominated in various currencies. This is to say, the pound price of a dollar is determined in a so-called flexible-exchange rate regime. Generally speaking, an exchange-rate regime refers to the institutional rules of the game that governments set unilaterally or multilaterally to determine how economic agents—individuals, corporations, an so on—in their respective countries engage in international financial transactions and, thus, determine exchange rates.
Currencies that trade in entirely unfettered markets are so-called free-floating currencies, which include the British pound, the euro, the Japanese Yen, the US dollar, and about twenty other so-called hard currencies. Other types of exchange-rate regimes include intermediate regimes, in which a government pegs—or, in other words, sets—the time path of the foreign-exchange value of its currency, and hard-peg regimes, in which a government essentially adopts a foreign currency. The euro is a particularly interesting example of a hard-peg regime within the nineteen countries that have adopted the euro, which floats freely in a flexible-exchange rate regime outside the euro area. For example, within the euro area, the euro in Spain is identical to the euro in Germany: a hard peg of 1 euro in Spain = 1 euro in Germany exists; however, the euro price of, say, a dollar is determined by the demand and supply for each currency in a flexible-exchange rate regime. Regime choice—that is, why a country establishes one regime over another—is quite nuanced and complicated.
In Figure 1, I illustrate, for example, three free-floating exchange rates: namely, euro / USD, pound / USD, and yen / USD, each relative to its value on January 2010; thus, a vertical-axis reading of, say, 1.4 in Figure 1 means the foreign-currency price of the dollar is 1.4 times—or 40 percent higher—than that price was in January 2020.
According to Figure 1, the euro, pound, and yen prices of the US dollar have generally increased over the last decade—because all three lines in Figure 1 rise from left to right. Most importantly for the purposes of this blog post and in relation to the Wall Street journal piece to which I referred earlier, these prices have risen suddenly and substantially in just the last few months. For example, from January 2021 until now, the foreign-exchange value of the yen—illustrated by the green line in Figure 1—has depreciated by about 30 percent. As of now, the yen price of the US dollar is the highest level recorded in twenty-four years: the last time the yen was so weak was August 1998.
Foreign exchange is an unintended target in the global fight against inflation.
For the most part, the reason why these and other free-floating exchange rates have weakened relative to the dollar lately is related to global inflation—general rises in domestic price levels around the world—and how central banks have chosen to deal with the problem. In Figure 2, I illustrate, for example, consumer-level inflation rates for the euro area, Japan, the UK, and the US.
According to Figure 2, in each of these four countries, the domestic purchasing power of the home currency—the purchasing power of the euro in the euro area, for example—has fallen, and so the price level and the rate of inflation have risen, substantially in the cases of the euro area, the UK, and the US; Japan is somewhat of an exception in this regard.
As Schooled readers know well, no matter the cause of inflation, the macroeconomic-policy approach to reducing inflation is to reduce aggregate demand. And, although in principle, macroeconomic policymakers could use monetary or fiscal stabilization policies to reduce aggregate demand, generally policymakers choose monetary policy in this case. This is because most macroeconomists reason (persuasively, in my view) that inflation is uniquely and ultimately an outcome of monetary policy. Recall, monetary policy is a macroeconomic stabilization policy conducted by a central bank when it targets the money supply, interest rates, and aggregate demand to achieve macroeconomic outcomes, including low and stable inflation and full employment. We could think of aggregate demand more concretely as the total amount of expenditures demanded by all sectors of the economy: namely, households, firms, governments, and foreign buyers of our goods and services.
According to conventional monetary theory, in the case of high and rising inflation, a contractionary monetary policy—one in which the central bank raises short-term, or so-called interbank, interest rates—is most appropriate. To be sure, since the start of 2022, the Federal Reserve has increased its target range on the fed funds rate from 0.0 — 0.25 percent to 2.25 — 2.50 percent; and the central bank has offered no indication that it intends to stop raising this target range anytime soon. Meanwhile, other central banks have been implementing contractionary monetary policies as well. For example, since July 2022, the European Central Bank, which is charged with maintaining price stability—think, low and stable inflation—in the euro area, has raised its marginal lending facility rate from 0.25 percent to 1.5 percent. Raising central bank short-term interest rates in this way generally raises other short-term market interest rates as well. In Figure 3, I illustrate, for example, interbank interest rates in the euro area, Japan, the UK, and the US; an interbank rate is one banks charge each other for overnight reserve balances—think, the inventory or the raw material of loans.
According to Figure 3, in the past few months, interbank interest rates have risen suddenly in the euro area, the UK, and the US; again, Japan is the exception—more on that in a moment. In each case I illustrate in Figure 3, the cause of the rise in the interest rate—or the lack thereof in the case of Japan—is the intentional outcome of contractionary monetary policy that central banks have unleashed to tame domestic aggregate demand and, thus, the rise in the domestic rate of inflation. Figure 3 also reveals that the US Federal Reserve has generally led the way: currently, interbank interest rates are highest in US money markets (orange line). I illustrate this pattern in Figure 4, where each line represents the time path of the difference between the US interbank interest rate and a foreign interbank interest rate; thus, according to Figure 4, a line above zero indicates the US interbank interest rate is above a foreign interbank interest rate.
According to Figure 4, the interbank interest rate in the US has risen above similar rates elsewhere, so that while interbank interest rates are rising elsewhere, because central banks elsewhere are contracting aggregate demand, the contraction instigated by the Federal Reserve is relatively large.
This current interbank interest-rate differential essentially explains why the dollar is so strong right now. The reason draws on the theory of interest-rate parity, which rests on the strong but instructive assumptions that country-specific risks assumed by investors—think, savers who buy financial assets in different countries—are the same across countries, and financial capital flows freely around the world (so investors can freely enter and exit any financial market). The principal implication of these assumptions is that, in the short run, nominal exchange rate movements between any two currencies—think the pound price of a US dollar or the euro price of a US dollar—are governed by the returns available in the two countries and the expected (short-term) movement of the exchange rate. For example, suppose interest rates in the UK and the US are both 6 percent, and suppose investors do not expect the pound price of the US dollar to change anytime soon. In this case, there is interest-rate parity: investors earn 6 percent no matter whether they invest in the US or the UK. Now, suppose the interest rate in the US rises to 8 percent, while the interest rate in the UK remains at 6 percent. In this case, the pound must depreciate against the dollar, creating an expected pound appreciation (of 8 – 6 = 2 percent in this case) that compensates investors in the pound for the lower interest rate on pound denominated assets. Thus, all else equal, differences in interest rates govern short-term movements in exchange rates.
This interest-rate parity condition and its implications for exchange-rate movements fit the data fairly—and, depending on your faith in international macroeconomic modeling, perhaps surprisingly—well. In Figure 5, I illustrate the pound price of the US dollar (in blue) along with the difference between the US interbank interest rate and the UK interbank interest rate (in red); close readers may rightly recognize the red line that I illustrate in Figure 5 as the green line I illustrate in Figure 4.
In Figure 5, the pattern that the theory of interest-rate parity implies is evident. This is to say, the pound price of the US dollar is positively correlated with the difference between US and UK interbank interest rates. Thus, although both the Federal Reserve and the Bank of England—the central bank of the UK—have contracted monetary policy and, thus, raised short-term interest rates, the US has led the way. Consequently, the pound has depreciated—and, in turn, the dollar has appreciated—so that the expected appreciation of the pound compensates investors in the pound for the difference in interest rates in the two countries. In Figure 6, I illustrate the analogous patterns for the euro price of the US dollar and the corresponding difference between US and euro interbank interest rates.
Again here, although both the Federal Reserve and the European Central Bank have contracted monetary policy and, thus, raised short-term interest rates, the US has led the way. Consequently, the euro has depreciated—and, in turn, the dollar has appreciated—so that the expected appreciation of the euro compensates investors in the euro for the difference in interest rates in the US and the countries in the European Monetary Union.
Finally, in the case of Japan, where the yen price of the US dollar is at a twenty-four year low, the interest-rate parity condition and its implications for exchange-rate movements are quite stark, because relative to the Bank of Japan—the central bank of Japan—the US Federal Reserve has contracted monetary policy by a relatively large amount and understandably so: as I illustrate in Figure 2, the rate of inflation in the US (and the UK and Europe) has far outpaced the rate of inflation in Japan. In Figure 7, I illustrate, as I do in Figures 5 and 6, the analogous patterns for the yen price of the US dollar and the corresponding difference between US and yen interbank interest rates.
According to Figure 7, from January 2021 until now, the foreign-exchange value of the yen (in blue) has depreciated by about 30 percent. Meanwhile, the difference between interbank interest rate in the US and Japan (in red) has risen from 0.20 percent to 2.50 percent, a relatively large differential that explains much of the yen’s recent depreciation.
So what is the Federal Reserve to do about the strong US dollar?
Ideally, nothing, and here is why.
As Schooled readers know well, the scope of impacts of monetary policy are broad; the short-term interest rate, the primary tool of monetary policy, is a blunt policy instrument that shapes macroeconomic patterns domestically and internationally whether the central bank intends these impacts. Although a strong US dollar is not the primary goal of US monetary policy, which is governed by a dual mandate to maintain maximum (domestic) employment and stable (domestic) prices, the interest-rate-parity condition implies that a relatively tight US monetary policy causes the foreign price of a US dollar to increase; this is to say, all else equal, relatively high US interest rates raise the foreign-exchange value of the US dollar. In any case, the Federal Reserve should not be distracted by the strong US dollar, which tends to reduce aggregate demand and, thus, high rates of inflation.