Dollar's rise may be coming to end amid economic tensions
The U.S. dollar has recently appreciated to its highest level in real terms since the start of 2017 and before that September 2003. Dollar appreciation weighed on oil prices in 2018 as prices in some non-dollar currencies hit record levels earlier in the year and dampened consumption growth. Yet there are signs that the dollar's rise may be coming to an end as trade tensions with China weigh and pressure to raise rates dissipates, lifting prospects for oil prices to recover.
For now, dollar strength has helped hold down U.S. inflation even as unemployment has fallen to its lowest level in decades. But it has contributed to a worsening trade deficit and cut the dollar value of overseas earnings of U.S.-based companies. The United States is currently running a mix of expansionary fiscal policy (tax cuts and increased spending on the military) and a less accommodative or contractionary financial policy (rising interest rates).
The consequence is an improvement in the trade-off between employment and inflation (internal balance) but a deterioration in the trade deficit (external balance). Exchange rate movements have suppressed inflation despite the booming economy but at the cost of declining international competitiveness despite tariffs. The strong dollar has posed a dilemma for the Federal Reserve: halting interest rates hikes runs the risk of pushing down the real exchange rate and pushing up inflation.
The Trump administration and the Federal Reserve are to some extent re-running the policy mix of the Reagan administration and the central bank under Paul Volcker in the 1980s. The Reagan administration's tax cuts and defence build-up coupled with higher interest rates caused the dollar to surge and the trade deficit to soar. The Reagan administration pressed trading partners to cut exports to the United States (especially cars, steel and electronics) and boost their currencies.
Eventually, the White House pushed the Fed to adopt a more accommodative policy, triggering the departure of the chairman. It is worth noting the current U.S. Trade Representative Robert Lighthizer was the deputy trade representative in the Reagan administration when it forced Japan to accept "voluntary export restraints" to curb its exports to the United States. The administration went on to press the other major economies to appreciate their currencies and depreciate the dollar as part of the Plaza Accord in 1985.
The strong dollar of the early 1980s worsened the demand destruction and oversupply of oil in the early 1980s and contributed to the price crisis of 1985 and 1986. Subsequent dollar depreciation likely helped steady oil prices in the second half of the 1980s, at least it did once Saudi Arabia's oil minister Ahmed Zaki Yamani was replaced and the kingdom abandoned netback pricing and its volume warfare strategy. Just as Japan was the target for U.S. policymakers in the 1980s complaining about unfair trading practices, China has become the target in the 2010s. The experience of the fiscal expansion, strong dollar and trade deficits of the 1980s hold important lessons for the next two years and a possible roadmap.
The trade war between the United States and China has pushed both economies as well as their trading partners towards a slowdown or even a recession in 2019. As economic growth slows, both countries are likely to become increasingly eager for a negotiated solution that kickstarts business activity and raises equity prices. The worse the economic news becomes, the greater the pressure on both countries, particularly the United States which holds a presidential election in 2020, to reach a deal.
Lighthizer's involvement suggests any eventual deal with China (and deals with the European Union and other trading partners) will likely employ some combination of managed trade to reduce the deficit. Voluntary export restraints, purchases of big ticket items such as aircraft and farm products, together with selective tariffs and quotas are likely to form part of the eventual deal. U.S. negotiators will also push for structural reforms on intellectual property, subsidies and state-owned enterprises, probably even harder than they did with Japan in the 1980s.
The Trump White House has already made its displeasure with the Fed over recent interest rate increases very clear. Signs of a domestic slowdown will give the central bank an opportunity to re-examine the case for further rises, or even contemplate a cut, if policymakers wish to do so, without more pressure from the White House. The White House has been vigilant over the strength of the dollar, pressing other trading partners not to depreciate their currencies further. It is not clear whether the administration will try to repeat the Plaza Accord or include exchange rate conditions in any trade with China.
Even without a formal exchange rate agreement, an end to U.S. interest rate increases could halt the currency's upward move and interest rate cuts would probably send it to lower again as they did between 2009 and 2011. In the short term, lower oil prices have been an important part of global rebalancing and will support economic activity in consuming countries and ultimately buy back some demand growth in 2019. But a scenario with lower U.S. interest rates, dollar depreciation, easing trade tensions and an improving global economic outlook could ultimately help push oil prices higher. Everything hinges on whether policymakers in the United States and China can find a way to avoid further escalation of their economic war and avert a prolonged global recession.
(With inputs from agencies.)
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