The Almighty Dollar

HIGHLIGHTS:

• The Fed had been the frontrunner for central bank rates but may have finally reached its top speed as other contenders play catch-up.
• A notable gap between the fed funds rate and rates abroad propelled the US dollar higher for most of 2022.
• Surges in the greenback can have rippling effects on the global economy, particularly worsening situations in developed nations.
• The US dollar has been on a downward trend. However, market risks are keeping safe haven assets in demand.

While the US appears to be the frontrunner in the race to combat inflation by raising interest rates, other contenders are catching up. At a pace not seen in decades, the Federal Reserve has raised borrowing costs by a whopping 4.75 percent in the past year, bringing the top end of its key overnight rate to 5.0 percent—a level not seen since 2007. Officials have been adamant that recent banking issues will not deter them from raising rates to an adequate level to quash inflation. Investors may have seen the last hike of this cycle in March, but the Fed could have one or two more in store if consumer price numbers don't go their way.

As the Fed rapidly raised interest rates over the past year, foreign central banks have been playing catch up, partly due to lower inflation expectations in Europe and other developed regions. Even now, the European Central Bank's key rate is 3.50 percent, the UK's is 4.25 percent, China's is 4.35 percent, and Canada's is 4.50 percent. Many other countries started raising their interest rates several months after the Fed, which caused a disparity in central bank borrowing costs. The relatively higher fed funds rate also drove Treasury yields higher and created an attractive opportunity for foreign investors. Those inflows helped boost the US dollar, which rose a staggering 19.3 percent from the start of last year to its high in September. At its high, the exchange rate versus a basket of other currencies was the most elevated it's been since 2002. That surge has also had a notable impact on the global economy via international trade, where developing nations had reduced capacity to purchase goods. Spillover economic effects were also an issue, which may have actually increased inflation in other countries.

Fortunately—or unfortunately for US citizens traveling abroad—the greenback has been on a declining trend since its peak in September. As the Fed looks to pause its rate increases and other central banks continue to tighten policy to close the gap, the dollar should continue to decline. That's evidenced by the euro-to-US-dollar rate—which had briefly fallen below one for the first time in 20 years—climbing back to 1.09 as of today. A weakening US dollar should bring a bit of relief to the global economy and may help buoy asset prices in some areas. That decline won't be a straight line, though. Recessionary and geopolitical risks are keeping safe haven assets in demand and could help prop up the greenback despite the headwinds.

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