By William Watts
The Federal Reserve’s aggressive efforts to wring out inflation have sent the U.S. dollar soaring to historic highs — further aiding the effort to get price pressures under control. Beware, however, the potential for unwanted side effects, a pair of economists warned in a new paper.
“The Federal Reserve has been among the most aggressive (if not early) tighteners, and the dollar has appreciated sharply since mid-2021. Determined disinflation by the Fed and continued appreciation of the dollar could lead to more intense debt troubles for a range of EMDEs (emerging market and developing economies),” wrote Maurice Obstfeld, economics professor at the University of California, Berkeley, and Haonan Zhou, a Ph.D economics student at Princeton University, in a paper to be presented Friday at the Brookings Papers on Economic Activity fall conference in Washington, D.C.
“Indeed, danger signals are flashing already,” they said.
The ICE U.S. Dollar Index /zigman2/quotes/210598269/delayed DXY +0.01% , a measure of the currency against a basket of six major rivals, fell 0.2% on Thursday, but this week hit its highest since 2002. The dollar has seen historic highs versus major rivals, trading above 144 Japanese yen /zigman2/quotes/210561789/realtime/sampled USDJPY -0.5113% this week for the first time since 1998, while the British pound /zigman2/quotes/210561263/realtime/sampled GBPUSD +0.3596% sank to a 35-year low versus the greenback.
The dollar pulled back more sharply on Friday, with analysts tying the move to a positive tone in the equity market that robbed the dollar of haven-related buying interest. The DXY dropped 1.1% but remains up 13% in the year to date.
Their worries stem in part from rising dollar-denominated debt in those economies over the course of the pandemic. A surging dollar makes it more difficult for borrowers in those countries to repay dollar loans.
Obstfeld, a former International Monetary Fund chief economist, and Zhou noted that more than 80% of emerging markets’ overall external debt liabilities are denominated in foreign currency, mostly U.S. dollars, and in some countries, “internal currency mismatch creates another potential fault line.”
“Not only does a stronger dollar itself lead to tighter financial conditions by weakening debtor balance sheets … heightened risk aversion in world markets tends to appreciate the dollar as investors everywhere seek safety, implying another channel of negative correlation between dollar strength and EMDE macroeconomic performance,” they wrote.
The paper said that emerging and developing economies can bolster their defenses against a rising dollar by keeping dollar-denominated debt in check, allowing flexible exchange rates and ensuring their central banks have strong anti-inflation credibility. The authors noted that several EMDE central banks began lifting interest rates last year, getting a jump on the Fed and other advanced-economy central banks, which may offer some buffer against a crisis but will slow domestic growth.
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