The outcome of three critical meetings this week will set the stage for the world economy for the next several months. The European Central Bank (ECB) is expected to raise its key interest rate by 0.25 per cent (25 basis points), the first such increase since 2011, with further increases planned for later in the year. The current level is at -0.50 per cent.
The US Federal Reserve Board, at its Open Market Committee meeting, is expected to increase interest rates by 75 to 100 basis points. Such a rise would bring the rate to between 2.50 and 2.75 per cent. The Bank of Canada already announced a 100 basis point hike last week.
And on July 31, the Executive Board of the IMF’s Special Drawing Rights (SDR), a basket of five major world currencies, will announce the new currency mix in the basket. The current distribution of an SDR is USD 41.73 per cent; Euro 30.93 per cent; Yuan 10.92 per cent; Yen 8.33 per cent, and Pound Sterling 8.09 per cent.
Biden, the dollar and trade
The SDR’s mix is decided every five years, with the last review in 2015 when the world looked very different. Britain is now no longer part of the European Union. Russia, which had occupied Crimea, is now in a full-scale war against Ukraine and controls more than 20 per cent of its neighbour. China has become a true global superpower. As the old saying goes, if China sneezes, the world around it catches a cold.
The Russian invasion of Ukraine is driving currency markets crazy because the attack highlights the importance of commodities in the world’s economy. Russia is a significant producer of oil, fertiliser chemicals, pig iron, and wheat. Ukraine also is a major producer of agricultural commodities, including wheat and soybean oil. With the war blocking the supplies of these essential commodities to global markets, the price of everything has risen.
With the West sanctioning Russia, where the Western alliance is beginning to feel the pain, the action has transferred to the currency markets. In a cataclysmic event not seen in 20 years, the Euro reached parity with the U.S. dollar. Some analysts expect the Euro to fall below the 1:1 level. The yen hasn’t fallen this much in at least 30 years. Meanwhile, the Russian ruble, shaking off sanctions entirely, is 32% stronger than at the start of the war.
During all this turmoil, the dollar has remained super strong.
Since President Biden took office, inflation in the US has risen steadily to levels not seen in 41 years. The US government has continued to borrow and spend for one emergency after the other, but most recently for fighting Covid, spending nearly $6 trillion. All the extra cash in people’s pockets and the extraordinarily low rates of interest that the Federal Reserve maintained for the last 13 years since the global recession created an imbalance in the supply and demand of the currency.
A critic could argue that the dollar should have weakened with the world awash in a supply of dollars. But, in the real world, the dollar’s value is evaluated against other currencies, and the central banks of the other countries also resorted to loose monetary policies where they too printed their currencies with gay abandon.
Geopolitical tensions
In April, the Fed saw the writing on the wall that inflation was heading into dangerous territory. Unconstrained by political forces, the central bank began to act. It raised short-term interest rates from about zero and has been doing so at every meeting of the FOMC, bringing it close to 175 basis points today. More ominously, the Fed announced that it was stopping its quantitative easing program where it had created money from thin air and flooded markets.
In a final blow, the Fed said that when bonds it had bought matured, the Fed would no longer allow those bonds to roll over and renew, demanding that the sellers of the bonds surrender cash and get back their pieces of paper. This amounted to a mopping effect. All the excess dollars in the global economy will slowly get vacuumed up to be taken back into the Fed’s vaults.
As the world’s safe haven, investing in the dollar makes sense to many investors. The rising interest rates make dollar-denominated bonds a better bet than riskier stocks. It’s little surprise that the S&P 500 has fallen 30 per cent since January 1. As investors worldwide seek refuge in the dollar, and the dollar supply is limited by Fed action, the dollar increases in value compared to other currencies. It also helps that the US is the world’s largest oil producer, so its economy is not as fragile as that of Europe, Japan, or China dependent on foreign oil.
As the default currency for international trade, the dollar’s value will likely only strengthen as the Fed tightens the money supply. The world has not seen the effects of such a super strong dollar. Soon countries won’t have sufficient resources to buy dollars to drive international trade. The case of Sri Lanka is a prime example. American exports (planes, machinery) will become more expensive, and American imports will become cheaper, worsening America’s trade deficit when the war in Europe rages on with no end in sight.
We are genuinely entering uncharted territory.