Why a strong dollar could trigger a cost-of-living crisis in emerging economies

A strong US dollar is driving inflation and slowing growth in emerging market economies as trade becomes more expensive
Only when Fed hawkishness affects US growth expectations will dollar demand begin to ease, but the peak may still be a way off

Chris Iggo

Published: 4:15pm, 18 May 2022

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The strength of global commodity prices, rising US interest rates and a strong dollar are all connected. They are all also contributing to the worsening growth and inflation outlook in economies across Europe, Asia and emerging markets in general.

Increased US dollar prices for commodities like oil and industrial metals creates an increased demand for the currency for transactional reasons. Higher bond yields and expectations of significant increases in US interest rates also fuel speculative demand for the greenback.

No reversal of this is likely until energy prices begin to subside, growth falters and the US Federal Reserve becomes significantly less hawkish. In short, it would take a significant growth slowdown or even a recession to bring the dollar down.

A strong dollar is not a deliberate US economic policy, but it suits the US at this stage of the inflationary cycle. All else being equal, currency strength helps contain inflation through limiting increases in import prices.

In turn, this reduces the need for even higher interest rates, which would bring about a sharp correction in the US housing market and raise the probability of a recession in 2023. This may happen anyway as there are signs that inflationary expectations are becoming unanchored.

The 0.6 per cent rise in core inflation in April signals that overall inflationary pressures are far from easing. As such, for now, markets remain of the view that the Fed has much more to do.

For the rest of the world, a strong dollar adds to inflation. Looking at the largest developed economies and comparing recent trends in inflation, it is obvious that there are global factors that are driving prices higher – namely, energy and supply chain-related shortages of certain manufactured goods.

Average inflation rates across countries have risen. However, the standard deviation of inflation across countries has started to increase after being very low in recent years. The big shift in the dollar’s relative value is key to this. Recent data on producer prices, for example, has seen much bigger increases in Europe than in the US.

A vendor pours cooking oil into a container at a market in Jakarta, Indonesia, on April 17. Both war and the pandemic have caused a steep rise in global cooking oil prices, hurting households and businesses as inflation soars. Photo: AP

The US dollar is exporting inflation and causing bigger relative price increases overseas. In March, producer price year-on-year inflation in the US was 11.5 per cent; in the euro area, it was 37 per cent.

Significant price increases for energy and food are hitting incomes everywhere. It is most obvious in certain emerging economies where signs of social unrest are appearing. Sri Lanka offers a salient example of what the potential political repercussions of a cost-of-living crisis for the poor can be.

In the euro area, the European Central Bank has had to accelerate its exit from super easy monetary policy. It looks likely to start raising interest rates in July in response to the inflation crisis, driven to a large extent by the euro cost of importing dollar denominated goods and commodities. In emerging markets, rising inflation is pushing interest rates higher.

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Indeed, it is a familiar pattern. Rising US rates push the dollar higher against emerging market currencies, causing higher inflation and rates domestically. This is not good for growth and tends to generate capital outflows from emerging markets, tightening financial conditions even more. If things carry on as they are today, we should expect to see numerous countries looking to the International Monetary Fund for assistance.

If the global economy is entering a new regime of higher inflation and with more differentiation of inflation rates across countries and regions, increased volatility in currency markets is inevitable. That is bad news for companies involved in international trade, for global investors and for consumers.

Countries that suffer from higher inflation will tend to depreciate their currencies over time to maintain competitiveness. Others may find their currencies are too strong at times, forcing central banks to focus more on that than on domestic economic conditions.

Central banks doing more harm than good as they seek to control inflation

Speculators will also take advantage of these macro trends – as they have on many occasions in the past – adding to volatility. Apart from the few lucky currency traders that make the right bets, few economic agents benefit when currency volatility is high. It adds to inflation, uncertainty on trade and costs to business.

The optimistic outlook is that dollar strength eases as markets conclude that we have reached peak “Fed hawkishness” and economic growth and inflation forecasts start to be revised down. Against the other major currencies, the dollar is still some way off previous peaks and there is the potential for further strength in the meantime.

But history tells us that as US growth expectations fall, the chances of dollar strength starting to reverse increase. That would be good news for the other regions of the world struggling still with the aftermath of Covid-19 and now a global inflation shock.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers