The economy most vulnerable to what could be further increases in relative dollar strength if the Fed does what it expects most and continues to force rates higher is the Eurozone.

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Traditionally, a weak currency should boost exports, but the impact of Europe’s reliance on Russia for energy has sent trade deficits skyrocketing across major European economies, energy costs soaring having outweighed any benefit from the euro’s depreciation in exports. Even Germany, one of the world‘s leading exporting economies, now runs a current account deficit.

The impending recession in Europe

The European Central Bank faces an inflation rate that tracks that of the United States – it was 8.6% last month. And it is even as the disparate economies of the euro zone are heading into a recession which, if accompanied by a rise in interest rates, could create a financial crisis for the over-indebted economies of the south of the Europe like Italy and Greece.

The ECB has no choice but to try to control the inflation rate by raising interest rates and withdrawing liquidity while trying to devise a political mechanism to prevent Italian debt returns. and Greece – already more than 200 basis points above those of the German Bunds – to burst further and precipitate a crisis and the threat of a fragmentation of the euro zone.

Rising interest rates and the energy crisis in Europe are causing a deep recession even as the sharp decline in the value of the euro is contributing to higher import prices, inflating the rate of inflation and requiring a response monetary policy than would be the case if the depreciation were less dramatic.

The situation in Japan is different. There is no inflation problem. However, it is experiencing a similar shock to energy and raw material costs; the one that generated its largest current account deficit in almost a decade.

Japan has not experienced the inflationary pressures of other major economies, mainly because there is no pressure from rising domestic wages and production costs that occurred during the recovery from the worst of the pandemic in the United States, Europe and elsewhere.

The weak yen and a weak economy, however, are hurting workers and consumers and have intensified the questioning of the ultra-expansive and debt-financed monetary policies that Japan has increasingly pursued over the past few decades as its economy stagnated.

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China’s economy has slowed considerably, although the main cause is its own harsh “zero COVID” policies.

He would be concerned about the capital flight triggered by the strength of the US dollar and also that its growth is almost stagnating despite a very strong export performance which has been helped by the weakness of the yuan.

The appreciation of the US dollar against most other currencies (the Australian dollar fell from over 75 US cents in April to below 68 US cents) will also have a big impact on developing economies due to their overexposure debt denominated in US dollars. Interest charges and principal repayments are increasing sharply.

“Inverted Currency War”

The extent and pace at which the greenback has strengthened will force central banks in other major economies to respond with higher rates than they otherwise would in economies where conditions are already deteriorating.

This prospect has been described as a “reverse currency war” or a series of attempts at “competitive revaluations” as central banks try to mitigate the effects on imported inflation and falling living standards of the US currency. strong.

This is the opposite of what countries, especially economies like China and Japan, have done historically. Past currency wars have been triggered by competitive devaluations in pursuit of export competitiveness and trade surpluses.

There have been calls for a 2022 version of the “Plaza Accord”, the 1985 agreement between the G-5 (now G-7) countries of the US, UK , France, Germany and Japan to act in concert to weaken the US dollar through their economic policies and their interventions in the foreign exchange markets.

There has been cooperation between the United States and Japan on exchange rate management since then, although there have been no major market interventions in this century, and currencies were a topic of conversation when US Treasury Secretary Janet Yellen met with Japanese finance. Minister Shunichi Suzuki this week.

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After the meeting, Yellen made it clear that she would not support any intervention aimed at weakening the US dollar, saying her government’s view was that G-7 countries should have market-determined exchange rates. The official joint statement after the talks, however, said the Russian invasion of Ukraine had increased exchange rate volatility and that participants had pledged to “cooperate as necessary” on monetary issues.

Thus, no bilateral or multilateral intervention is planned – for now – to stop the rise and rise of the US dollar. The potential for individual central banks to step up and attempt a reverse currency war remains, of course.

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