The dilemmas of the dollar in a volatile market


The US dollar’s recent surge, particularly against major Asian currencies, has sparked a wave of concern in financial markets. With the Japanese yen teetering on the brink of collapse and China potentially contemplating devaluation, the financial landscape appears precarious. The pressing question is whether anything can be done to stem the greenback’s rise, and if so, whether it should be done.

The yen’s sharp decline has been particularly alarming. As of the end of April, it had plunged to ¥160 per dollar, marking a 13% drop since the start of the year and over 50% since early 2021. Similarly, the South Korean won has depreciated by about 10% against the dollar in 2023, and the Indonesian rupiah has hit a four-year low against the greenback. Despite these dramatic shifts, the broader nominal dollar index, which measures the dollar against a basket of currencies, has risen by less than 3% since the beginning of the year.

The dollar’s strength is not an anomaly; rather, it reflects the robust performance of the US economy compared to other regions. Rapid US economic growth has tempered expectations for disinflation, prompting the Federal Reserve to maintain high interest rates or at least delay cuts that markets had anticipated. In contrast, slower-than-expected growth in other economies has reduced their central banks’ urgency to combat inflation, making rate cuts more likely in those regions.

For instance, the Bank of Japan’s (BOJ) much-discussed abandonment of yield-curve control in March resulted in a modest interest rate increase to 0.1%. This accommodative stance remains suitable until the BOJ firmly tackles deflation. With the Federal Reserve’s benchmark federal funds rate at 5.25-5.5%, a strong dollar against the yen seems justified.

The current situation raises the question of whether there is genuine cause for concern. Japanese financial institutions are not particularly vulnerable to the dollar’s rise, given their extensive international investments, including significant holdings in the US. These assets’ values fluctuate with the dollar, providing a natural hedge. While Japan has experienced a significant increase in import prices-over 50% in the last four years-this has not translated into runaway inflation. Consumer prices rose by approximately 2.5% year-over-year in April, aligning with the BOJ’s targets.

The fear is that a collapse in confidence could trigger a further yen depreciation and uncontrollable inflation. While theoretically possible, this scenario appears unlikely given Japan’s prolonged struggle with deflation.

For those concerned about the dollar’s strength, what measures could be taken to address it? Market intervention is one option. The BOJ’s suspected intervention in late April, which briefly strengthened the yen to 154 per dollar, exemplifies this approach. However, sustained exchange rate impacts from such interventions typically occur only when they signal future monetary policy changes. The BOJ’s covert intervention aimed to avoid policy shifts, not signal them.

Equally, the Federal Reserve is unlikely to cut rates in response to the dollar’s appreciation. Fed models indicate that a 3% rise in the broad dollar index could reduce inflation by at most 0.3%, and even this modest effect is likely temporary. Thus, the rationale for maintaining high US interest rates remains strong.

Another possible approach is coordinated intervention, where central banks like the Fed and the BOJ collectively act in the foreign exchange market. The Plaza Accord of 1985, named after the New York City hotel where it was agreed, is often cited as a successful example of such an operation moderating dollar strength. However, today’s context is different. The Fed’s primary focus is on controlling inflation, making coordinated foreign exchange intervention less appealing. Moreover, the dollar had already peaked and begun to fall before the Plaza Accord was implemented. Recent weak US job numbers suggest a similar peak might be occurring now.

A potential game-changer could be a second presidential term for Donald Trump, who advocates for low interest rates and views a strong dollar as a disadvantage for US exporters. Rumors suggest he may seek to appoint a Fed chair aligned with his views or even mandate the central bank to follow presidential directives. Such a shift could lower the dollar’s value but might also destabilize US financial markets.

In sum, while the dollar’s strength against Asian currencies has stirred anxiety, the broader context indicates that this strength reflects underlying economic fundamentals rather than market dysfunction. Japan and other countries affected by the strong dollar have mechanisms to cope with these changes, mitigating the risk of financial instability. Market interventions, whether unilateral or coordinated, offer limited and temporary relief unless accompanied by broader policy shifts.

Ultimately, the current policy stance of maintaining high interest rates in the US seems appropriate given the prevailing economic conditions. However, political developments, particularly in the US, could introduce significant uncertainties. For now, the best course of action may be to monitor the situation closely, responding to economic data and market signals rather than preemptively altering policy in reaction to currency movements.


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