The year of the rising dollar

It has become fashionable among economic pundits to wring their hands about the dollar’s prospects based on the marked deterioration in the United States’ public finances. It has also become commonplace for Treasury Secretary Janet Yellen to wish for a weaker dollar and to eschew the traditional U.S. Treasury line that a strong dollar is in the country’s interest.

In expecting or hoping for a weaker U.S. dollar, both the dollar bears and Yellen seem to be forgetting a basic truth. As the late Paul Volcker was fond of reminding us, for the dollar to weaken, it has to depreciate against other currencies. Especially in the wake of the pandemic, and at a time that the global “everything” asset and credit market bubble appears primed to burst, it is far from obvious whether any major currency could pose a serious challenge to the dollar’s position as the world’s dominant international reserve currency.

To be sure, the United States’ deteriorating public finances raise the prospect that its external current account deficit will widen from its already relatively high level. With the Biden budget stimulus projected to raise the U.S. budget deficit to 13 percent of GDP, one must expect that the country’s overall savings rate will decline significantly. At the same time, with U.S. economic growth expected to be the highest among the G-7 industrialized countries, one must expect that U.S. import growth will outstrip its export growth.

While a widening current account deficit could weigh on the dollar, in today’s world of open capital markets, it is what happens to capital flows that really matters for the determination of the dollar’s value. On this score, it is a rapidly growing United States economy that is bound to enjoy a considerable advantage over its G-7 partners.

With a U.S. economy likely to overheat by the end of the year, it must be only a matter of time before the Federal Reserve starts backing away from its presently highly expansive monetary policy stance. The same cannot be said of the languishing European and Japanese economies, which have not received anything like the massive budget stimulus that the U.S. economy has received. With the European Central Bank and the Bank of Japan likely to considerably lag the Federal Reserve in raising interest rates, capital is likely to flow to the U.S. to take advantage of the relatively favorable interest rates that it will have to offer. 

In the context of rising U.S. interest rates, one must also expect that the U.S. dollar will rise strongly against the emerging market currencies. This is especially the case considering that in the wake of the COVID-19 pandemic, most Latin American and African countries are now characterized by record debt levels and gaping budget deficits. In a world of higher U.S. interest rates, these countries can no longer expect to be kept afloat by investors stretching for yield. Instead, they should be bracing themselves for a sudden stop in capital flows.

Yet another reason for expecting dollar strength in the year ahead stems from its continued status as a safe haven currency in times of world financial market stress. There is now every prospect that we will again get world financial market stress as rising U.S. interest rates cause today’s global “everything” equity price and credit market bubbles to burst. Should that occur, global investors must once again be expected to seek the safe harbor of the deep and highly liquid U.S. Treasury bond market as they did during the 2008-2009 world financial market crisis.

The dollar’s likely strength over the coming year is not to suggest that there is no reason to worry about the longer consequences of the poor state of the country’s public finances and its widening external current account deficit. Rather, it is to say that in today’s context of a Japan with even more troubling public finances than the U.S. and a languishing European economy that appears on its way to another round of the Eurozone sovereign debt crisis, one can leave worrying about any imminent U.S. dollar decline for another day.

As Paul Volcker might have said, the U.S. dollar will appreciate over the coming year not because of its strong economic fundamentals. Rather, it will do so because it will remain the tallest midget in the room.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney. f