The Strong Dollar: Good for U.S., Dangerous for Global Economy

While other currencies are declining, the U.S. dollar is on a roll. An index of the dollar versus major currencies is trading around a two-decade high. The nominal effective exchange rate of the U.S. dollar appreciated by 12 percent between December 31, 2021, and September 26, 2022, according to JPMorgan estimates. During the same period, the yen’s effective rate depreciated by 12 percent, the pound’s by 9 percent and the euro’s by 3 percent. Against the dollar alone, movements are larger: sterling has depreciated by 21 percent, the yen by 20 percent, and the euro by 16 percent.

One reason for this strong dollar is the string of crises that have rocked the globe, including the coronavirus pandemic, supply chain chokeholds, Russia’s invasion of Ukraine, and the series of climate disasters that have imperiled the world’s food and energy supply. Another cause is the efforts to control inflation (more on that, later).

The economic outlook in the United States, however cloudy, is still better than in most other regions. The U.S. economy seems to be on a firmer footing, inflation looks to be more broad-based, and the Federal Reserve appears to be more unconstrained in terms of raising policy rates and tightening policy than many other parts of the world.

So, now may be a good time to visit London, Tokyo, or Rome, right? Maybe, but American investors and consumers should not be waving the flag too vigorously.

Everything Is Connected 

The dollar is the world’s reserve currency—the one that multinational corporations and financial institutions, no matter where they are, most often use to price goods and settle accounts. Energy and food tend to be priced in dollars when bought and sold on the world market. Much of the debt owed by developing nations is also priced in dollars. Roughly 40 percent of the world’s transactions are done in dollars, whether the U.S. is involved or not, according to a study done by the International Monetary Fund. Importers of those goods need to hold dollars for trade purchases. Exporters tend to hold funds in short-term U.S. Treasuries for future transactions. The size and liquidity of the U.S. Treasury market provides a stable backdrop for global trade and investment.

There simply aren’t many alternatives to the dollar that will fill these needs. The euro plays a large role in financial transactions, but its fragmented bond markets and long period of negative interest rates have limited its usage. Japan’s zero-interest-rate and yield-curve-control policies make it unappealing. There is always speculation about China’s yuan becoming more prominent as a global currency, but it’s not even freely convertible due to capital controls.

In an anxious world, the dollar has traditionally been a symbol of stability and security. The worse things get, the more people buy dollars. Investment tends to flow into higher yielding currencies, and the dollar has rallied in part because the Fed, as it seeks to contain inflation, is hiking interest rates more aggressively than some other nations’ central banks.

The European Central Bank, which has long resisted steep rate hikes, must be concerned with energy shocks across Europe as it tightens policy. As the pound hit a record low against the dollar, the Bank of England had to intervene to prevent pension funds from collapsing. The Japanese central bank has persisted with very low interest rates. These moves have created a wide gap in interest rate levels between the U.S. and other economies, which has resulted in investors seeking higher returns moving their money to America.

The situation is particularly fraught because so many countries ran up above-average debts to deal with the fallout from the pandemic; now, they face renewed pressure to offer public support as food and energy prices soar. Research on the impact of a strong dollar on emerging nations found that it drags down economic progress across the board.

Inflation creates a pile-on effect. Even in countries where inflation is not as high, central banks feel pressure to raise interest rates to bolster their currencies and prevent import prices from skyrocketing. Already banks in Argentina, the Philippines, Brazil, Indonesia, South Africa, the United Arab Emirates, Sweden, Switzerland, Saudi Arabia, the United Kingdom, and Norway have raised interest rates.

Helping Inflation

The overriding reason for the strong dollar is the fight against inflation. Despite the pain a strong dollar is causing, most economists say that the global outcome would be worse if the Fed failed to halt inflation in the United States.

Many other factors impact inflation besides the Fed. The U.S. dollar exchange rate plays a role in inflation. For example, as U.S. exports are sold to Europe, buyers need to convert euros to dollars to make the purchases. If the dollar is strengthening, the higher exchange rate causes Europeans to pay more for U.S. goods. As a result, U.S. export sales may decline if the dollar is too strong.

Also, a strong dollar makes foreign imports cheaper. If U.S. companies are buying goods from Europe in euros, and the euro is weak or the dollar is strong, those imports are cheaper. The result is cheaper products at U.S. stores, and those lower prices translate to low inflation.

Cheap imports help keep inflation low since U.S. companies that produce goods domestically have to keep their prices low to compete with cheap foreign imports. A stronger dollar aids in making foreign imports cheaper and acts as a natural hedge for reducing inflation risk in the economy.

Why a Strong Dollar Is Good

Americans holding U.S. dollars can see those dollars go further when traveling or living abroad, affording them a greater degree of buying power. Because local prices in foreign countries are not influenced greatly by changes in the U.S. economy, a strong dollar can buy more goods when converted to the local currency. Expatriates will also see their cost-of-living decrease if they still own dollars or receive dollars as income.

Goods produced abroad and imported to the United States will be cheaper if the manufacturer’s currency falls in value compared to the dollar. Luxury cars from Europe, such as Audi, Mercedes, BMW, Porsche, and Ferrari, could all fall in dollar price. If a European luxury car costs €70,000 with an exchange rate of 1.35 dollars per euro, it will cost $94,500. If the exchange rate falls to 1.12 dollars per euro, the same car selling for the same amount of euros would now cost $78,400.

As the dollar continues to strengthen, the price of imports will continue to fall. Other lower-cost imports will also fall in price, leaving more disposable income in the pockets of American consumers. U.S. companies that import raw materials from abroad will have a lower total cost of production and enjoy larger profit margins as a result.

Foreign companies that do a lot of business in the U.S. and their investors will benefit. Multinational corporations that have a large number of sales in the U.S., and thus earn income in dollars, will see gains in the dollar translate to gains on their balance sheets. Investors in these companies should be rewarded as well.

The status of the dollar as a world reserve currency is bolstered with a strong dollar. While some countries, including Russia, Iran, and China, have questioned the status of the U.S. dollar as the de facto world reserve currency, a strong dollar helps keep its demand as a reserve high.

Why a Strong Dollar May Not Be Good

Visitors from abroad will find the prices of goods and services in America more expensive with a stronger dollar. Business travelers and foreigners living in the U.S. but holding on to foreign-denominated bank accounts, or who are paid incomes in their home currency, will see their cost of living increased.

A weaker currency would make imports, which are primarily denominated in dollars, more expensive. When those items are raw materials or intermediate goods, their higher costs can further increase local prices. For tourists traveling to the U.S., it means that their euros or pounds would be worth much less. U.S. companies that do a lot of their business abroad will be hurt; the profits they make in other countries will decrease in dollar value.

Foreign governments that require U.S. dollar reserves will end up paying relatively more to obtain those dollars. A strong dollar bodes trouble for emerging economies, particularly those that have a large amount of dollar-denominated debt: countries such as Turkey, Argentina, and Ghana. An appreciating dollar could make the cost of servicing debt unsustainable in some of those countries. For countries that rely heavily on imports, a strong dollar will add to inflation concerns. It will also erode their extremely crucial dollar reserves, making it difficult for them to pay for their imports.

Just as imports become cheaper at home, domestically produced goods become relatively more expensive abroad. An American-made car that costs $30,000 would cost €22,222 in Europe with an exchange rate of 1.35 dollars per euro; however, it increases to €26,786 when the dollar strengthens to 1.12 per euro. Some have argued that expensive exports can cost American jobs.

Conclusion: Revert to the Mean

Companies based in the U.S. that conduct a large portion of their business around the globe will suffer as the income they earn from foreign sales decreases in value on their balance sheets. Investors in such companies are also likely to see a negative impact. While some of these companies use derivatives to hedge their currency exposures, not all do. Those that do hedge may only do so in part.

Also, because most of the world’s commodities are priced in dollars, resources such as oil, wheat, and soybeans grown in emerging markets are going to be more expensive.

Opinions about the effects of a strong dollar may depend on one’s place on the economic ladder. But economic theory predicts that currency fluctuations will eventually revert to a mean since cheap foreign goods should increase the demand, which will raise prices. At the same time, expensive domestic exports will have to fall in price as demand for those items declines worldwide until, ultimately, some equilibrium exchange level is found.

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