The power of the almighty US dollar is a bit of a mystery

Obstfeld and Zhou argue that because a lot of world debt is denominated in dollars, a rising dollar creates balance sheet problems around the globe. That makes sense. But I still find the apparent size of the effects startling. I’m especially puzzled by the strength of the relationship between the dollar and the prices of global commodities like oil and wheat.

Put it this way: You might think — or anyway, I might think — that when the dollar rises against the euro, the price of, say, oil would fall in dollars but rise in euros. But that’s not what they find; confirming a result I’ve seen many times, they find that “a one per cent appreciation of the dollar is associated with a much larger per cent fall in average global commodity prices.” When the dollar rises against the euro, the price of oil doesn’t just fall in dollars; it falls in euros, too.

But why is the dollar up so much? At first sight, the answer seems obvious: It’s all about the Fed. The Federal Reserve has been raising interest rates to bring inflation down, which, other things being equal, makes buying dollar assets more attractive and raises the dollar’s value.

But the Fed isn’t the only central bank hiking rates. International economists normally believe that exchange rates are driven by long-term, not short-term, rates — and long-term rates depend not just on what a central bank has already done but on what investors expect it to do in the future.

So here’s the funny thing: Long-term rates have risen as much in Europe as they have in the United States. In December 2021, the interest rate on US 10-year bonds was 1.47 per cent; the corresponding rate in Germany was minus 0.38 per cent, reflecting investors’ belief that the European economy faces many years of weak growth. As of this morning, the US rate was 3.31 per cent, up 1.84 points since December; the German rate was 1.69 per cent, up 2.07 points over the same period. So Europe seems to have had as much or more effective monetary tightening as the US Why, then, has the euro plunged?

The dollar may be other countries’ problem, but even a purely self-interested America needs to live in the world our policies help shape.

It’s not hard to come up with possible reasons, especially the fact that Vladimir Putin’s de facto gas embargo is hitting Europe hard. But in any case, dollar strength seems to be about more than the Fed’s fight against inflation.

Whatever the reasons, however, it’s clear that the strong dollar is inflicting a lot of pain on economies around the world. Once again, it’s our currency but their problem. Should this influence policy?

Claudia Sahm, a former Fed economist (inventor of the famous Sahm Rule recession indicator), has been a strong critic of the Fed’s hard line on inflation and more recently has been arguing passionately that the Fed has a responsibility to consider the damage its policies are inflicting on the rest of the world. She has a point.

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Unfortunately, I don’t think the Fed will listen — yet. Federal Reserve officials are still deeply worried about the possibility that high inflation will get entrenched in the US economy, and that concern will dominate everything else until there are clear signs that underlying inflation is coming down. Once the Fed feels that it has some breathing room, however, it should start taking international repercussions into account. The dollar may be other countries’ problem, but even a purely self-interested America needs to live in the world our policies help shape.

This article originally appeared in The New York Times.

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