A Strong Dollar Is Hurting Other Countries. Should the Fed Care?
The Federal Reserve is making life tough in some emerging markets. Investors are pulling money out of those economies and putting it into U.S. assets to take advantage of the recent increase in interest rates engineered by the Fed. The inflows have pushed the dollar up 40 percent since its 2011 low against the currencies of a broad set of trading partners (currently 26), according to a Fed exchange rate index that adjusts for differences in national inflation rates.
Here’s the question: How much should the Fed chair, Jerome Powell, and his band of rate-setters care about whether their policies inflict harm on the rest of the world? Should it be a central concern or scarcely relevant? Experts disagree.
First, let’s talk about the harm that’s being inflicted. Patricia Cohen of The Times reported on Monday that the strength of the dollar is driving up the prices of imported food, fuel and medicine in Nigeria and Somalia while pushing Argentina, Egypt and Kenya closer to defaulting on their debts. In Indonesia, she wrote, people protesting against higher fuel prices have clashed with police.
This is reminiscent of the 1980s, when Fed rate hikes during the tenure of the former chairman Paul Volcker precipitated a series of debt crises that whacked most of the developing world, especially Latin America, which suffered a “lost decade” of growth. (To be fair to the Fed, it’s not the only force pushing up the dollar. U.S. currency is almost always a refuge in times of distress.)
Even rich countries are under pressure this time. The euro has fallen from more than $1.20 last year to less than a buck — about 98 cents lately. The euro’s weakness raises the cost of imports that are priced in dollars, such as oil, which worsens Europe’s inflation problem, notes Torsten Slok, the chief economist at Apollo Global Management, a private equity firm. “The euro going down is really bad for Europe,” he told me.
For the Federal Reserve, though, the strong dollar is mostly great. It makes imports cheaper, which helps lower inflation. It also cools off the U.S. economy through trade: Because imports are cheaper, some will displace domestically produced products, and the strong dollar makes exports from the United States more expensive, causing some U.S. exporters to cut output. Normally this chilling effect would be bad, but the U.S. labor market has been so hot that the Fed welcomes some cooling off. (I happen to think the Fed may be overdoing its rate hike trajectory, but that’s a separate issue.)
Some economists say that since the dollar is the world’s dominant reserve currency, the United States, and by extension the Fed, has a special obligation to manage it in a way that takes all of the dollar’s stakeholders’ interests into consideration. That might mean coordinating with other central banks to make sure they don’t over-tighten policy.
Taking other nations into account isn’t purely altruistic. It’s also realistic. If Fed rate hikes cool growth abroad, that will feed back into slower growth in the United States — say, by shrinking the market for U.S. exports. If the Fed and other central banks don’t take such feedback effects into account, they could overdo their tightening.
“There is a danger that central banks jointly create an unnecessarily sharp global recession,” Maurice Obstfeld, an economist at the University of California, Berkeley, and a former chief economist of the International Monetary Fund, warned this month in a draft paper for the Brookings Papers on Economic Activity. That downturn, he and his co-author, Haonan Zhou, wrote, could happen “through uncoordinated policies that effectively export inflation to trading partners through actions that strengthen their own currencies.”
When Raghuram Rajan was the governor of the Reserve Bank of India, he wrote a working paper with Prachi Mishra, saying: “Aggressive monetary policy actions by one country can lead to significant adverse cross-border spillovers on others.” At the time the issue was cutting rates to combat slow growth rather than raising rates to combat fast growth, but the concept was similar. “If countries do not internalize these spillovers, they may undertake policies that are collectively suboptimal,” he wrote.
While Rajan and Mishra didn’t advocate direct coordination by central banks, they proposed a system of self-discipline in which the banks would code their actions green, orange or red, depending on the severity of their spillover effects on other parts of the world. (Don’t do the red stuff.)
But a lot of economists have serious misgivings about efforts by central banks to take into account how their actions will affect other nations. I spoke this week with Ayhan Kose, who is the chief economist of the World Bank’s equitable growth, finance and institutions group. He and two co-authors wrote a report this month called “Is a Global Recession Imminent?” It warns that the “mutually compounding” effects of central banks’ efforts to get inflation under control “could produce larger impacts than intended, both in tightening financial conditions and in steepening the growth slowdown.”
So you’d think Kose would favor coordination by central banks in the name of self-restraint. But no. Too tricky to get right, he said. “There are many things in life that we would like to do,” he told me. “And these are good things. But the question is, can we do them in an effective way? Policy coordination is one of them.”
Pulling punches in the fight against inflation would be a big mistake, Kose said: “We think inflation is the No. 1 macroeconomic challenge. Central banks need to be decisive, clear, credible and, if necessary, aggressive.”
Early in my career, when I covered Eastman Kodak for The Associated Press in Rochester, N.Y., I wrote about the Plaza accord of 1985, which was hatched at the Plaza Hotel in New York City. It was an agreement by five big industrialized nations including the United States to reduce the overvaluation of the dollar, which was harming U.S. exporters, such as Kodak. It worked, but it was an exception. For the most part, the big economies set interest rates for domestic conditions and let their currencies float freely.
The Fed’s mandate from Congress is to focus on just two objectives: full employment and price stability. International coordination may help achieve those objectives, but it’s not obvious how. “It’s hard to talk about collaboration in a world where people have very different levels of interest rates,” Powell said at a news conference after the Federal Open Market Committee meeting that ended on Sept. 21. “If you remember, there were coordinated cuts and raises and things like that at various times, but really, we’re in very different situations,” he added.
Oleg Itskhoki, an economist at the University of California, Los Angeles, wrote in an email that while there’s a theoretical case for coordination, “it is not even clear how this coordinating mechanism could be established (e.g., how other countries could compensate the U.S. for departing from its unilaterally optimal policy and the mandate to pursue domestic price stability).” Itskhoki is the 2022 winner of the John Bates Clark Medal, given to the American economist under 40 who has made the most significant contribution to economic thought and knowledge.
In 2019, Şebnem Kalemli-Özcan of the University of Maryland, College Park, delivered a paper at the Federal Reserve Bank of Kansas City’s annual Jackson Hole conference explaining the outsize influence of the United States on the rest of the world economy, especially emerging markets. It’s all about global investors’ risk perceptions, her paper said. She and two co-authors from the Federal Reserve system have built on the Jackson Hole paper with a new piece detailing the key role of U.S. financial intermediaries, including the big banks, hedge funds and pension funds, which pull back from risky emerging markets when prices fall to protect their balance sheets from becoming overleveraged.
While Kalemli-Özcan makes a strong case that financial crises often originate or are amplified in the United States, that doesn’t lead her to conclude that the United States should be trying to protect emerging markets by limiting rate hikes. She said governments in emerging markets need to take responsibility for protecting themselves by, among other things, keeping inflation under control and not getting overly indebted.
“That would actually be a bigger disaster, if the Fed steps back because it worries about the rest of the world,” she told me. “That’s going to be horrible on their own policy credibility. That will hurt the world even more, based on our research.”
The Readers Write
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The writer is president of the California College of Barbering and Cosmetology.
Quote of the Day
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— Jane Austen, “Sense and Sensibility” (1811)
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