Dollar’s Strength May Be Making Rest of World Weaker

Typically, the foreign exchange market is fairly stable. Currency fluctuations tend to be minor. But that trend may be shifting.

Interest rate hikes have caused volatility, creating dramatic fluctuations in the price of money and competition among national currencies that has strengthened the U.S. dollar. The Japanese yen has dropped more than 20% against the dollar, the pound sterling and the euro more than 15%, and the Chinese yuan by more than 10%. The last time declines like these were seen was in 1994.

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In addition to the Federal Reserve’s raising of interest rates, other factors have led to the dollar spike. The energy crisis caused by Russia’s invasion of Ukraine has affected Europe more than the U.S., since the continent relies more on Russian energy sources, while the U.S. produces significant quantities of natural gas and oil itself. Also, the possibility of an economic slowdown has increased demand for the dollar, which is considered a safe-haven currency.

But a strong dollar affects prices. According to BBVA Research, “The depreciation of the euro contributes to increasing inflationary pressure by making imports more expensive. Conversely, the appreciation of the U.S. dollar helps curb inflationary pressure in the United States.”

This is particularly troubling for emerging economies. “An expensive dollar is generally bad for emerging economies that hold dollar-denominated sovereign debt, but it also makes exports to the U.S. cheaper,” said Ignacio de la Torre, Chief Economist at Arcano Economic Research.

Usually, currency devaluations increase competition, since they make a country’s exports of products and services cheaper. This advantage isn’t being realized, however. “The energy shock that could drag Europe into recession outweighs the benefits of a depreciated euro, especially because external demand is declining due to a global economic slowdown,” said Natalia Aguirre, Director of Analysis and Strategy at Renta 4, a Spanish financial institution.

Meanwhile, foreign governments have taken action to prop up their currencies. The Japanese Finance Ministry announced drastic measures it hasn’t taken in two decades, and the Bank of England stepped in to stop the pound from dropping and calm markets after the government announced a tax-cut plan that would increase its borrowing costs.