Is it time to curb US dollar strength?

The intervention to curb dollar strength could be on policymakers’ agendas if the greenback does not start to slide of its own accord.

>> A risk of more US dollar strength in the near term

If left unchecked, dollar strength could cause significant difficulties and that’s why intervention to curb dollar strength should be on policymakers’ agendas if the greenback does not start to slide of its own accord.

There have been lots of references made to the fact that the world is going back to the 1970s and early 1980s with its high inflation and recession problems. It is worth noting what happened to the dollar through this period. The dollar soared dramatically between 1980 and 1985, rising nearly 50% in trade-weighted terms as new Fed Chairman Volker pushed policy rates dramatically higher to tame soaring inflation. The dollar even kept rising well after both inflation and rates peaked (in 1980 and 1981 respectively).

In the end, the only thing that seemed capable of turning the US dollar around was large, coordinated, and unanticipated FX intervention by the world’s major central banks. Once this happened, the dollar lost all of its prior near-50% gain within two-and-a-half years.

But is today’s situation in any way comparable? At first glance, it seems not. For a start, the dollar has not risen anything like as much as the early 1980s and today, the dollar’s effective exchange rate is still around 40% below the 1985 peak. The dollar is still overvalued on most metrics but definitely not as out of kilter with economic fundamentals as we saw in the early-to-mid 1980s. The squeeze from US policy tightening is not as severe as it was back in 1985. Volcker’s Fed pushed real policy rates to over 9%, which compares to the negative real rate of around 7% today (if we use CPI).

It is also worth noting that, these days, the Fed has unlimit  ed FX swap lines with a number of major central banks and more limit  ed lines with others. These help to supply dollar liquidity when financial market tensions are high and dollar borrowing costs in the FX market rise.

>> “Weaponising” the US dollar

Another factor to be mentionned is that global finance ministers have not been as ready to step into the market to conduct FX intervention as they were in the 1980s and 1990s. The Fed, for instance, has not intervened since 2011 and G7/G20 finance minister’s communiques regularly talk about the fact that currency values should be set by the market.

One final issue is that the Fed is still tightening policy and, most often, currency intervention to weaken a currency (the dollar) when monetary policy is being tightened is quite a struggle.

As mentioned earlier, the Fed had already been easing some years before it intervened with others to lower the dollar in 1985. In other words, it was intervening with the (monetary policy wind), not against it, as it would be doing today.

For all these reasons, and probably more, the idea of coordinated intervention to weaken the dollar is simply not on anybody’s radar it would seem, least of all the policymakers. But does that mean there’s no case to be made for intervention?

In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, intervention right now does not appear appropriate and could be a failure given the point we made about the Fed still tightening policy. However, should the dollar continue to rise after the rate cycle– and inflation– have peaked, piling on the misery for both developed and developing countries, the case for action could become overwhelming. Furthermore, it might not be a good idea to wait to act as finance ministers did in 1985. Just like preemptive rate hikes, pre-emptive intervention has much to recommend it. Should the dollar continue to rise and if finance ministers accept that they need to nip the strength in the bud before it results in too much global damage, we could be looking at action next year.