As Fed Battles Inflation, the Dollar Keeps Its Swagger

Bet against the dollar at your peril.

After the dollar’s sharp rally since July, it may be tempting to do so. Earlier this year, before the rebound, spot currency traders made good money wagering that the dollar would decline from the 20-year highs it reached in 2022. And while the dollar dominates world trade, a host of nations, including China and Russia, are maneuvering to unseat it.

At the same time, political conflicts in the United States — like the debt-ceiling brinkmanship in the spring and subsequent credit downgrade, and the current risk of a government shutdown — have threatened to dim the dollar’s luster.

But the Federal Reserve’s decision on Wednesday to hold rates at an elevated level is likely to buttress the dollar in foreign exchange markets.

Still, an underlying truth abides: The dollar remains the linchpin of the global economy. It is the currency around which nearly all others revolve, the world’s haven in times of trouble — even when that trouble emanates from the United States itself.

What’s more, the relative vigor of the U.S. economy and the Fed’s tight monetary policy have been pushing up the value of the dollar against most other currencies. Since July, the U.S. Dollar Index, which tracks the greenback against six other important currencies, has risen more than 5 percent.

While it’s down from last October’s peak, it remains more than 40 percent higher than in 2011. Against the Japanese yen and the Chinese renminbi, the dollar has been strong enough to warrant discussion of government currency intervention in Asia to reduce the foreign exchange disparities.

The Fed and the Dollar

“Higher for longer” is a Wall Street summary of the Fed’s interest rate policy, and it is apt. Fed projections released on Wednesday suggested that to bring inflation down to its target of 2 percent, the Fed may need to move the federal funds rate up to 5.625 percent from the current range of 5.25 to 5.5 percent by the end of this year, and to hold rates above 5 percent in 2024.

In a news conference on Wednesday, Jerome H. Powell, the Fed chair, said that the Fed would remain “data dependent” in making it decisions, but that until inflation came down, it would do whatever it took.

“If the economy comes in stronger than expected, that just means we will have to do more in terms of monetary policy to get back to 2 percent,” he said.

Higher for longer may well apply to the dollar, too.

Because U.S. interest rates are significantly higher than those of most major countries, and the economy is growing more robustly, U.S. securities have been pulling in money, in turn bolstering the dollar’s value

In many ways, the Fed is “the central banker to the world,” said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, in an interview. Its decisions cascade throughout foreign exchange markets, affecting the economies of a great many nations.

For the American government, the dollar’s central role in global finance pays immense dividends. U.S. national debt has reached $33 trillion, a mind-boggling number that is adding fuel to the fight in Congress over government spending. But fiscal issues in the United States would be much more complicated without the dollar’s global primacy.

The Federal Reserve has the ability to create money that is accepted universally, and the Treasury can issue dollar-denominated debt that is in high demand in world markets. This gives the government extraordinary fiscal flexibility. U.S. sway in world affairs would be constrained if it did not possess this special financial power.

Headwinds and Tailwinds

For American consumers, the highly valued dollar reduces inflation, enabling the purchase of imported goods at lower prices. And for canny travelers, it can mean cheaper and better meals and hotel rooms in countries whose currencies have declined against the dollar.

For American multinational businesses, the highly valued dollar is a mixed blessing, with some corporate divisions benefiting and others hurting.

Scores of U.S. business executives have bemoaned what they call revenue “headwinds” unleashed by the dollar’s strength, which saps foreign profits when converted into American currency and can lead to higher prices for their products abroad. This was a major theme of corporate earnings calls with Wall Street analysts in 2022 and early this year.

The highly valued dollar remains a problem for multinational companies. In Apple’s August earnings call, for example, Tim Cook, the chief executive, said that while the company had done extremely well over all, it continued “to face an uneven macroeconomic environment, including nearly four percentage points of foreign exchange headwinds.” In July, Andre Schulten, chief financial officer of Procter & Gamble, said, “Foreign exchange rates continue to be a headwind, and based on current rates, we now expect a $400 million after-tax impact.”

But many companies have learned to hedge against the dollar’s strength, which in 2023 is no longer as clear and powerful a tailwind for U.S. companies focused on the domestic market, and a detriment for internationally focused businesses, as it was last year. A review by Bespoke Investment Group of U.S. companies’ recent stock performance, based on the extent of their foreign revenue exposure, produced inconclusive results. Individual strategy matters more for a company’s revenue stream than the movements of the dollar.

Global Ripples

Oil and the dollar have had a close and contentious relationship. During the 1970s oil shocks, prices soared and vast sums of money flowed from oil-consuming countries like the United States to oil producers like Saudi Arabia — and back to the United States as investments. Leonard Silk, a New York Times financial columnist, fretted that the flow of these “petrodollars” might destroy the global financial system.

That didn’t quite happen, but for many years, higher oil prices contributed to high inflation and slower economic output — stagflation — in the United States. The flow of petrodollars enhanced the international status of the dollar while reducing its value in foreign exchange markets. For decades, when oil prices rose, the dollar tended to decline.

But in a major shift that dates roughly to the start of Russia’s war in Ukraine early in 2022, oil prices and the dollar have been moving in tandem. That is an important finding of an April study by the Bank for International Settlements, the “bank for central banks.”

If the change in this relationship holds up, the latest surge in energy prices won’t hurt the dollar, and may help it. Establishing the reasons isn’t easy. They may partly be that fossil fuel energy is far less important to the economy than it was 50 years ago, even if rising gasoline prices are painful for consumers and irksome in the Fed’s fight to tame inflation.

But mainly, I suspect, the reason is that thanks to increased production of oil and natural gas at its shale fields, the United States since 2019 has become a net exporter of energy. If anything, then, energy revenues are boosting the dollar, not impairing its value.

For countries that are net energy importers, however, this is a double whammy. Oil is customarily priced in dollars, and converting most currencies to dollars is costly.

Low-income emerging-market countries that are commodity importers are particularly vulnerable, the International Monetary Fund has found. If the United States enjoys an exalted status in global markets, thanks to the strength of the dollar and of U.S. Treasuries, a host of countries come under heightened stress when the dollar soars. Countries like Ghana, Sri Lanka, Egypt and Pakistan have already had trouble managing their debt.

There are always exceptions to these trends. The Mexican peso, Colombian peso and Brazilian real have all been strong performers against the dollar this year — partly making up for earlier declines.

For U.S. investors, ignoring these issues and simply focusing on U.S. securities has been a successful strategy in recent decades. But it is reasonable to assume that international stocks and bonds will outperform U.S. securities at some point, and that the dollar’s value will fluctuate. Broad international diversification through global stock and bond index funds is a prudent approach.

But one thing I would not suggest is making a big bet against the dollar.

“I don’t see any currency that can replace it,” Ms. Jones of Schwab said, “and it has held its value for a very long time.”

Even periodic crises in Washington have failed to dislodge global confidence in the dollar. A new test is underway in the congressional battle over federal spending. But it’s in the U.S. government’s interest to maintain the dollar’s special status.