Dramatic times, it’s said, call for dramatic measures. And so, we’ve seen that happen. The halcyon forty years of the Volcker FED-induced moderating inflation have been supplanted – perhaps due to energy market dislocations, perhaps from fiscal excess and monetary neglect, perhaps from official obtuseness. US inflation now exceeds 8% on a year-over-year basis, and has been prompting the Powell FED to react. The FED has tightened, and dramatically. Getting a grip – rather, a throttle – on galloping inflation is the objective; the sharp appreciation of the US dollar has been the by-product.  This is having heavy potential credit consequences for those servicing US dollar-denominated liabilities; also, the eventual correction, or at least accordion-like reversion of the US dollar exchange rate value will be consequential for those who are wrong-footed or at least flat-footed. Cross-border lenders and investors must foster agility and account ably for their activities.

Tread softly, or rather carefully. Everything seems to be a minefield these days, with perceptions of fundamental value being always recast as inflation continues to alarm and central banks bring the heat. The markets desire price stability – all kinds of price stability, and of course good prospects, too. In fact, those in the markets, policy makers, all manner of savers and investors would like to expunge the lack of stability from mundane consumer price inflation, fixed income and equity markets, the foreign exchange markets and for that matter the purely political and geopolitical realms.

Seeking that stability, the Jerome Powell FED has been tightening in a way not seen in forty years, seeking to restore the inflation moderation that the Paul Volcker Federal Reserve tenure had wrought.

But maybe thoroughly earnest efforts at restoring stability do yield unintended consequences. The cross-border investor or lender must not only consider the direct effects, but also those possible knock-on effects. Those are the effects – the term of art is “second-order effects”, I think – that can impair exposures, as the second-order ones can catalyze even further second-order effects (maybe third-order ones?) such as dented political stability and hobbled obligor credit-worthiness.

One such effect to consider is the sharply appreciated exchange rate value of the US dollar.

The Financial Times columnist Martin Wolf does so in part in his recent posting “Why the Strength of the Dollar Matters” (see the Financial Times, 9/27/22). Wolf notes that America’s brusque encounter with inflationary pressure necessitated the Federal Reserve’s actions, which are entailing recessionary results everywhere as other central banks emulate the FED.

Other countries are feeling some of the same inflationary pressures the US is feeling if not more so, namely the squeeze from elevated energy markets. Fed action is also prompting them to mimic so as to protect exchange rate value. Wolf wonders if they have (that is, the world’s monetary authorities) done too much: “…A more important question is whether monetary tightening is going too far, and in particular, whether the principal central banks are ignoring the cumulative of their simultaneous shift towards tightening…” Reflecting on what central banks are supposed to do, Martin Wolf responds to the question he poses, “…But central banks have little option: they have to do ‘whatever it takes’ to curb inflation expectations…”

The actions that Jerome Powell and his Federal Reserve Bank are taking are far-reaching, because the dollar does matter, as Mr. Wolf states. While the US economy, still the largest, it is not as dominating as it once was, it still is, well, dominant – one representing a huge market for global exporters, and a salient destination for global investors and savers. As Mr. Wolf notes as well, the US dollar remains predominant in foreign exchange transactions, official reserves holdings, cross-border loans, trade invoicing, international debt security issuance and in the flow of SWIFT payments.

What’s interesting though is that nature abhors a vacuum, so therefore we’re never operating in one. We’re always operating in the context of something, and actions we take never only have the just-desired effects we intend.

The dramatic FED tightening (which appears to be ongoing) has been leading the global monetary authority pack. Other reserve currencies and less traded ones have been losing value against the dollar thus far, with the British pound down by 21% so far on the year, the yen down by 20%, and the euro falling in value this year against the US dollar by roughly 16%.

US dollar strength, though, has been tripping up US trade competitiveness. US terms-of-trade, or the ratio of US prices of exportable goods vs. the price for importable goods has worsened by an historic magnitude since the advent of US monetary tightening. The US terms-of-trade index posted at 117.99 as of the second quarter of this year, according to the US Bureau of Economic Analysis. That level is the highest since the 123.64 mark recorded at the end of QII in 1979.

Poor terms-of-trade can translate into declining balance of payments performance, which can mean pressure on exchange rate value – for any country. As of QII of this year, the US posted a current account deficit total approximating 3.6% of US GDP. This does represent a deficit level less severe than the roughly 6% one recorded in the bubbling US economy of 2006, just on the eve of the Global Financial Crisis. Yet, US shortfalls have been worsening during the past several quarters, the deterioration of US competitiveness could be worsening this trend. There ultimately can be a limit on worsening competitive terms-of-trade and worsening balance of payments, too. The dollar may have to shift, with consequences for global risk-takers.

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