The most vulnerable economy to what could be further increases in the dollar’s relative strength if the Fed does what most expect it to and continue to force rates higher is the eurozone.

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Conventionally a weak currency ought to boost exports, but the impact of Europe’s reliance on Russia for its energy has seen the trade deficits of the major European economies blow out as soaring energy costs have overwhelmed any benefit from the euro’s depreciation in exports. Even Germany, one of the world’s major export economies, is now running a current account deficit.

Europe’s looming recession

The European Central Bank is confronted by an inflation rate that is tracking that of the US – it was 8.6 per cent last month. And that’s even as the disparate economies within the eurozone are heading towards a recession that, if coupled with rising interest rates, could create a financial crisis for the overly-indebted southern European economies like Italy and Greece.

The ECB has no choice but to try to get control of the inflation rate by raising interest rates and withdrawing liquidity while scrambling to devise a policy mechanism for preventing the yields on Italian and Greek debt—already more than 200 basis points above those of German bunds – from blowing out further and precipitating a crisis and the threat of eurozone fragmentation.

Higher interest rates and Europe’s energy crisis spell deep recession even as the steep fall in the value of the euro helps increase import prices, swell the inflation rate and necessitate a stronger monetary policy response than would be the case if the depreciation were less dramatic.

Japan’s circumstances are different. It doesn’t have an inflation problem. It is, however, experiencing a similar energy and raw materials cost shock; one that has generated its biggest current account deficit in nearly a decade.

Japan hasn’t experienced the inflationary pressures of other big economies, primarily because there is none of the pressure from rising wages and domestic production costs that has occurred during the recovery from the worst of the pandemic in the US, Europe and elsewhere.

The weak yen and a weak economy are, however, hurting workers and consumers and have intensified questioning of the ultra-expansive, debt-funded monetary policies Japan has increasingly pursued in recent decades as its economy stagnated.

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China’s economy has slowed dramatically, although the main cause for that is its own harsh “zero COVID” policies.

It would be concerned about capital flight triggered by the strength of the US dollar and also that its growth is almost flat-lining despite a very strong export performance that has been aided by the weaker yuan.

The appreciation of the US dollar against most other currencies (the Australian dollar has fallen from more than 75 US cents in April to less than 68 US cents) will also heavily impact developing economies because of their over-exposure to US dollar-denominated debt. Interest costs and principal repayments are rising sharply.

‘Reverse currency war’

The extent and rate at which the greenback has strengthened will force the central banks in other major economies to respond with higher rates than they would otherwise deploy in economies where conditions are already deteriorating.

That prospect has been described as a “reverse currency war,” or a series of attempted “competitive revaluations” as central banks try to dampen the effects on imported inflation and reduced living standards of the strong US currency.

That’s the opposite of what countries, particularly economies like China and Japan, have historically done. Past currency wars have been ignited by competitive devaluations in pursuit of export competitiveness and trade surpluses.

There have been some calls for a 2022 version of the “Plaza Accord,” the 1985 agreement among the then G-5 (it’s now G-7) nations of the US, the UK, France, Germany and Japan to act in concert to weaken the US dollar through their economic policies and interventions in currency markets.

There has been co-operation between the US and Japan on managing exchange rates since then, albeit there haven’t been any major interventions in the market this century, and currencies were a topic of conversation when the US Treasury Secretary Janet Yellen met Japanese finance minister Shunichi Suzuki this week.

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After the meeting, Yellen made it clear that she wouldn’t support any intervention to weaken the US dollar, saying her government’s view was that the G-7 countries should have market-determined exchange rates. The formal joint statement after the discussions, however, did say the Russian invasion of Ukraine had raised exchange rate volatility and that the participants had pledged to “co-operate as appropriate” on currency issues.

So, there is no bilateral or multilateral intervention planned – yet -- to halt the rise and rise of the US dollar. The potential for individual central banks to act and attempt a reverse currency war does, of course, remain.

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