Shortly after taking the post of Treasury Secretary in 1971, John Connally told a group of European finance ministers that the U.S. dollar “is our currency, but your problem.” His context was a devalued dollar and inflation that would rise in Europe as a result. More than 40 years later, the dollar remains a problem, but according to the U.S. Federal Reserve, the problem is now ours.
In minutes released this week of the discussion at its September 17 meeting, the Fed argues that the recent dollar rise both threatens U.S. manufacturing exports and keeps a lid on inflation by keeping the cost of dollar-denominated commodities low. The dollar had risen about 5.5% on a trade-weighted basis from the beginning of July when that meeting took place. It had risen almost another 3% before pausing early this month.
Markets were clearly spooked, or jubilant, depending on whom you ask. Certainly U.S. equities enjoyed the prospect of more easy money, while the jitters were felt in a rush to bonds, with the U.S. 10-year yield dipping below 2.30% this week – lows not seen since June of last year.
The dollar’s strength in this latest round has a bit of a twist. Whereas earlier bouts of dollar strength were rooted in episodes of sudden risk/flight to quality and growth differentials among economies, the dollar’s driving strength now is the gaping divergence in interest rates between the U.S. and the rest of the world. That certainly has something to do with the U.S. Fed trying to ratchet back expectations of U.S. rates rising too far too soon.
The dollar, as both driver and indicator of global growth, is seeing its influence seep into other institutional warnings as well. Earlier in the week, the IMF released its quarterly update to its World Economic Outlook, and shaved another 0.1% off its expected growth rate for the global economy this year to 3.3%. It had been as high as 3.7% back in April.
IMF Managing Director Christine Lagarde warned last week that the world could be entering a “new mediocre” phase, defined broadly as good growth in the U.S. and UK, poor growth in Europe and Japan, and a mixed picture in emerging markets depending on the country.
My View: The dollar can’t be blamed for all ills, and I think the Fed is clearly overreaching on this a bit, but we see the dollar staying strong into the end of the year.
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