A currency headwind for the US economic recovery

Among the more striking international economic developments over the past year has been the marked appreciation of the U.S. dollar. U.S. policymakers would be ignoring this development at their peril. Since not only is the recent sharp dollar appreciation likely to both dampen U.S. economic growth and reduce inflation; it is also all too likely to be a harbinger of further significant dollar appreciation in the months ahead that could have a material impact on the U.S. economic outlook.

{mosads}Since August 2014 alone, the U.S. dollar has appreciated by around 15 percent against a basket of currencies. Particularly striking has been the dollar’s 20 percent appreciation against the euro and the Japanese yen. However, the dollar’s appreciation has not been confined to those two currencies. Rather, it has also appreciated by substantial amounts against a number of major emerging market currencies including the Brazilian real, the Russian ruble and the Turkish lira.

Past experience suggests that a stronger dollar has an adverse impact on U.S. export performance and a dampening affect on price inflation. It also suggests that this impact might take anywhere from between a year and 18 months to fully work its way through the U.S. economy. According to International Monetary Fund estimates, if the 20 percent dollar appreciation over the past year is sustained, it should be expected to shave off around a full percentage point from U.S. gross domestic product growth and reduce inflation by around 1 percent from the level that it would otherwise have been.

While many factors have a bearing on a country’s currency movements, it would seem to be no accident that the U.S. currency started appreciating at an accelerated rate beginning in the third quarter of last year. That appreciation coincided with the Federal Reserve’s signaling that it was about to end its massive quantitative easing program, which saw its balance sheet increase to over $4.5 trillion. It also coincided with clear indications that the Bank of Japan would continue with its aggressive quantitative easing program to support a stuttering Japanese economy. At the same time, the European Central Bank was signaling that it would soon move toward quantitative easing to prevent the European economy from falling into a deflationary trap.

In the months ahead, there is every reason to expect that the U.S. dollar will continue to appreciate. One reason is the very different cyclical position of the U.S. economy from that of the other major industrialized countries. While the U.S. economic recovery at last seems to have gained traction, the same might not be said of the European and the Japanese economies. The European economy has succumbed to outright price deflation while its economic outlook is threatened by a resumption of the Greek economic crisis and by heightened geopolitical tensions in Russia and Ukraine. At the same time, the Japanese economic recovery continues to be fragile as deflationary pressures again appear to be manifesting themselves.

An equally compelling reason to expect further dollar appreciation is the very different phases of the monetary policy cycle in which the major industrialized countries now find themselves. Against the backdrop of a steadily improving U.S. labor market, the Federal Reserve is now actively considering when it will start an interest rate hiking cycle. By contrast, the European Central Bank has pledged itself to keep interest rates low indefinitely and is now about to launch its 60 billion euros a month bond-buying program. Meanwhile, the Bank of Japan has every intention to continue with its aggressive quantitative easing program. The one pursued until recently by the Federal Reserve pales in comparison.

A further significant appreciation of the dollar would be particularly problematic for a number of major emerging market economies that are already struggling to sustain their recoveries. According to the Bank for International Settlements, the corporate sector in the emerging market economies has borrowed in excess of $2 trillion in dollar-denominated debt. Any further dollar appreciation could subject these corporations to major financial stress. That in turn could cloud the economic outlook of what in recent years has been the most dynamic part of the global economy.

In determining the timing and the pace at which it will normalize U.S. interest rates, the Federal Reserve would be ignoring recent exchange rate movements at its peril. The movements that have already occurred constitute both a major headwind to the U.S. economic recovery and a dampening influence on inflationary expectations. This would be all the more so the case in the event that we were to get further significant dollar depreciation as the monetary policies of the major industrialized countries remain out of sync.

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.