What the stronger dollar means for economies and markets

  • Describe why the dollar has been so strong
  • Explain how the stronger dollar impacts monetary policy around the world
  • Describe how the strength of the dollar impacts the US economy
What the stronger dollar means for economies and markets

While 2022 has been a year dominated by a range of market and macroeconomic events, one factor that underpins all of them is the strength of the US dollar against other currencies. 

That factor either mitigates or amplifies the losses in equity portfolios, depending on the allocation to assets exposed to the greenback. 

But the bigger issues may be around the impact of the strength of the dollar on the economies of the rest of the world.

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As of October 25, the day Rishi Sunak became prime minister, sterling was 16.5 per cent down against the dollar since the start of 2022. 

While some of the decline is a function of the market being spooked by the quality of the government in the UK, it is also a story of the dollar being “the asset of last resort, the ultimate safe haven”, says Felix Wintle, equity fund manager at Tyndall. 

He adds that US interest rates rising at a rapid pace also contributed to this.

Stefan Gerlach, a former deputy governor of the Irish central bank, and currently chief economist at EFG Bank in Zurich, says: “The depreciation of the currencies of other economies against the dollar will raise inflation in these economies and induce central banks to tighten monetary policy.

"The inflation effect is amplified by the fact that much of international trade is invoiced in dollars. (In turn, that means that the appreciation of the dollar will have a much smaller effect on US inflation since foreign exporters will keep their US dollar prices unchanged and instead pocket stronger profit margins.)

"Tighter monetary policy in these economies will reduce growth and lower asset prices.”

Exporting inflation

The negative impact of this was first hinted at by Katherine Mann, a member of the Bank of England’s Monetary Policy Committee, who said the UK may have to raise rates at a similar trajectory to the US or risk inflation becoming entrenched.

This is because most of the commodities upon which economies rely, notably oil and copper, are priced in dollars, regardless of where they are traded.

A stronger dollar relative to sterling and the euro, means the prices of these commodities is rising for those economies, regardless of the underlying demand and supply characteristics. 

This, says Gilles Moëc, chief economist at Axa Investment Management, means the US is effectively exporting inflation to the rest of the world, “and it is putting longer-term inflationary pressures into those economies”.

When policy makers are lifting or cutting rates, they usually do so with the aim of achieving an interest rate that neither increases inflation nor reduces growth, this is known as the neutral rate, or R*.    

But if the US continues to lift rates, and the UK and eurozone are obliged to follow suit to combat the imported inflation from the US, this could mean those central banks having to set an interest rate higher than the neutral rate – that is, a rate of interest so high it restricts growth in those economies.