US dollar strength may impact global economy; Capital Economics explains why it hasn't yet


A stronger U.S. dollar has been making headlines recently, with the greenback reaching record highs against various currencies, raising questions about its potential impact on the global economy. While some experts warn of the dangers posed by a strong dollar, others argue that its consequences may be overstated

The virile dollar has been on a relentless tear in 2024, muscling its way higher against other major currencies for four consecutive months now.

The ICE U.S. Dollar Index, which pits the dollar against a basket of six rival currencies, is up a robust 1.1% in April alone – marking its strongest monthly performance since January. At this torrid pace, the index is headed for its longest monthly winning streak since last September.

Moreover, this stubborn dollar surge shouldn't come as a surprise given the rude health of the American economy.

With domestic demand still buoyant and inflationary pressures proving stickier than expected, the Federal Reserve has felt emboldened to keep interest rates higher for longer. This hawkish policy stance, resisting market expectations for rate cuts, has continued propelling the dollar's relentless ascent.

While a powerful greenback is a boon for U.S. consumers by restraining import prices and making overseas travel more affordable, it risks exporting inflation to the rest of the world. By making imported goods pricier in local currency terms, a muscular dollar could fan the flames of inflation abroad while acting as a headwind to global trade and economic activity.

The dollar's virility also compounds the debt burden for foreign borrowers, making their dollar-denominated loans costlier to service.

Moreover, abrupt swings in exchange rates breed uncertainty over the future valuation of foreign currency assets and liabilities, Neil Shearing cautioned:

significant financial dislocation that threatens broader macro stability

Neil Shearing

However, the British economist contends the current dollar dominance is unlikely to precipitate a worldwide domino effect of currency catastrophes – at least not yet. While formidable, the 4.1% year-to-date rally in the Dollar Index to around 105.60 has been a "steady rather than abrupt" ascent, lacking the sort of dizzying spike that could severely wrong-foot markets.

What's more, Shearing reminds us that a currency's inflationary potency hinges on several variables including an economy's dependence on imports, precisely what goods it imports, and the magnitude of the exchange rate move.

There's no universal rule of thumb, as paradoxically a stronger dollar can actually defray global import inflation by depressing commodity prices denominated in the resurgent currency.

Historically, periods of dollar strength have tended to follow – rather than drive – global economic slowdowns, as heightened risk aversion prompts investors to pile into the perceived safe-haven greenback during turbulent times.

So while the ripple effects of the almighty dollar certainly warrant vigilance, Shearing's analysis suggests widespread currency chaos or systemic threats are improbable for now.

The U.S. stock market seemed to share this relatively sanguine view on Monday. Despite the dollar's unrelenting surge, Wall Street managed to grind higher, with the S&P 500, Dow Jones Industrial Average, and tech-heavy Nasdaq Composite all eking out modest gains.

Demand for blue-chip tech titans like Tesla and Apple helped power the advance, indicating equity investors aren't currently transfixed by the dollar domination narrative.

Conclusion

The dollar's ascent has been relatively steady rather than shockingly abrupt, while factors like trade flows and commodity prices could mitigate some of the inflationary fallout. With the powerhouse American economy showing few signs of buckling, the dollar's reign of strength may persist for the foreseeable future.

However, unless more severe exchange rate shocks emerge, Shearing believes global markets can likely weather the dollar's dominance without falling into crisis mode. For better or worse, the mighty greenback remains the pre-eminent global reserve currency.