Will de-dollarization push down inflation?

The flags of China and Brazil at the booth of Brazil at the 24th China Hi-Tech Fair in Shenzhen, Guangdong province.

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We’ve been arguing since well before the pandemic that deglobalization and demographics were likely to end the era of ultra-low inflation in developed nations. The former, because harmful trade actions of the type used by former President Trump and maintained or even increased under current President Biden, were likely to increase firms’ costs. The latter because a projected surge in the dependency ratio (the ratio of the elderly to working-age people in developed nations) would create a rise in demand relative to supply and so pull prices up.

In the event, we’d argue that not only have these things materialized, but both Ds have been turbocharged by the pandemic. Deglobalization has surged thanks to a growing distrust of China in the West and the consequent movement of supply chains to costlier sources as a result. At the same time, adverse demographics in developed nations have been turbocharged by what some have called the ‘great resignation, with its resultant impact being incredibly tight labor markets and accelerating wage inflation.

These days, such arguments are not particularly controversial. What might be more controversial is to suggest that another ‘D’, de-dollarization, could help push inflation back in the other direction. It is controversial because many dispute that any dedollarization has happened or that it is likely in the foreseeable future.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, thinks that there is a drip-feed of evidence that the dollar’s role is waning. Yesterday, for instance, China and Brazil agreed to a deal that will see trade between the two conducted in their own currencies and not through the dollar, as is still a very common practice. This is not a small measure, particularly for Brazil, given that China is its largest trading partner. It follows other similar actions, some of which have been caused by the US itself, such as the sanctions levied on Russia. But it is not just in terms of trade invoicing that there has been this drip feed of de-dollarization.

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We also see it in terms of global FX reserve holdings as more central banks have shifted away from the dollar. Of course, there is still a huge gap between the trade in goods, services, and financial claims done in dollars and those done in other currencies. Nobody, including ourselves, can suggest that any move to a more multi-polar currency world will be quick.

So, unlike the pandemic, which seemed to turbo-charge the inflationary effects of deglobalization and demographics, Mr. Steve Barrow doesn’t see any plunge in inflation due to a turbo-charging of de-dollarization. However, over the long haul, we do think that efforts to reduce reliance on the dollar will bear disinflationary fruit. One-on-one, more immediate, level transacting trade through direct currency exchange, rather than the third party of the dollar, could lower transaction costs for firms and hence prices. A second, potentially more important factor is that if de-dollarization reduces the ability of tighter monetary policy in the US to impart significant currency weakness on others, then inflationary pressure can surely be minimized.

The role of higher US rates and dollar strength in kicking off an adverse global financial cycle has been reduced by global efforts, particularly from the US, to ensure a steady flow of dollars. We see this right now, for instance, as major central banks up their weekly dollar auctions to a daily frequency in order to prevent a banking panic from morphing into a global funding drought. So far, this seems to have worked.

In the long haul, if US efforts to supply dollars are supplemented by a lower demand for dollars thanks to de-dollarization, the scope for dollar strength to emerge and play havoc with currencies—and so lift overseas inflation—will be reduced.