A near-10% drop in the value of the US dollar since its March high has given rise to two distinct narratives. The first takes a short-term perspective, focusing on how a depreciation could benefit the US economy and markets; the second takes the long view, fretting over the dollar’s fragile status as the world’s reserve currency. Both narratives contain some truth, but not enough to justify the emerging consensus around them.
Several factors have combined to put downward pressure on the greenback (as measured by the DXY index of trade-weighted currencies) in recent weeks, resulting in a depreciation that has reversed almost half of the appreciation of the last ten years within the space of just months.
As the US Federal Reserve has loosened monetary policy (actually and prospectively) in response to a worsening economic outlook, the income accruing to dollar-denominated safe havens, such as US government bonds, has declined. And with US-based investments having lost some of their relative attractiveness, there has been a shift in holdings in favor of emerging markets and Europe (where the European Union last month agreed to pursue deeper fiscal integration).
There also are indicators of lower capital inflows into the United States. House purchases by foreigners appear to have decreased again, owing in part to the US government’s embrace of inward-looking policies and the related weaponization of trade and sanction measures.
With the exception of Lebanon, Turkey, and a few other countries that have experienced even sharper exchange-rate depreciations than the US, most currencies have strengthened against the dollar. But among those with appreciating currencies, the reactions to this generalized phenomenon have been far from uniform.
Some countries, particularly in the developing world, have welcomed the reversal, because their previous currency weakness had been contributing to higher import prices, including for foodstuffs. Moreover, a weaker dollar provides them with greater scope to support domestic economic activities through more stimulative fiscal and monetary measures.
But the reaction has been less welcoming in the other advanced economies. Japan and eurozone member states, in particular, fear that currency appreciation could threaten their own economic recovery from the COVID-19 shock. Also, the Bank of Japan and the European Central Bank now have to worry that they are not only reaching the limits of their policy effectiveness, but could also be putting their economies at greater risk of collateral damage and unintended consequences.