December 31, 2016 Patrick Oliver-Kelley

2017 not 1957

The US Dollar is 40% above its lows in 2011, its sharpest rise ever against a basket of rich-country peers. This latest surge is in prospect of a shift in economic policy mix in America. Trump will cut taxes, and spend more public funds on fixing our crumbling infrastructure. Such a big fiscal boost will lead the Fed to raise rates at a far faster rate to check inflation. Zippier growth in the US should be welcomed world-wide for its knock-on effect, but, recalling the Reagan era widening budget deficits and high interest rates, reminds us that, that episode caused trouble abroad. Today, the dollar has become more pivotal. That makes a stronger dollar more dangerous for the world and for America.

Bonding Cement

America’s clout as another country’s major trading partner is smaller, dropping from 44% in 1944 to about 32% twenty years later. But the dollar’s supremacy as a means of exchange remains unchallenged. An estimate of a de facto countries whose currencies move in line with the dollar, encompasses 60% of world’s population and 60% of its GDP. This kind of dollar denominated debt amounted to about $10 trn, a third of it in emerging markets.

When the dollar rises, so does the cost of servicing this debt. Cheap offshore borrowing during the good times, caused an increased supply of local credit. Capital inflows pushed up local asset prices, encouraging further borrowing (recall the US housing boom that crashed landed in 2008) Not every dollar got invested, some ended up in bank accounts for other uses.

A strengthening dollar sends this cycle in reverse. As the dollar rises, borrowers husband cash to service the increasing cost of their own debts. As capital flows out, assets prices fall. The upshot is that credit conditions are bound ever more tightly to the fortunes of the dollar. Watch out Brazil, Chile, and Turkey.

For America the trade balance will worsen as the strong dollar sucks in imports and its exports demand softens. A bigger deficit raises the chance that Trump acts on his threat to impose steep tariffs on imports from China and from Mexico. If Trump succumbs to his protectionist instincts, the consequences will be disastrous. The global economy is weak and the dollar’s strength will enfeeble it further.

If interest rates were to move higher, as they just did recently and are likely to do so over the next year, not only would this interfere with Trump’s policy agenda, but those increases would be passed on to consumers and businesses who borrow money at rates based on government bonds. Rising rates could cramp the whole economy and make a lot of people upset.

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