The Dollar Is Still King in Europe, and It’s Swaying Interest Rates
U.S. currency remains critical to European inflation and growth
By Tom Fairless
May 28, 2023 12:01 am ET
27
The dollar has lost little of its global dominance despite some countries’ push to use other currencies. Photo: Kerem Uzel/Bloomberg News
FRANKFURT—It’s not just Americans watching anxiously to see if the Federal Reserve raises rates or the U.S. slides into recession; so are Europeans, and indeed many other countries. That’s because for all the talk of deglobalization and de-dollarization, the dollar still reigns supreme, and financial and trade ties between the U.S. and key partners are as strong as ever. In Europe’s case, they’re even stronger.
The European Central Bank tried to chart a different path from the Fed early last year, signaling it would hold rates low as the Fed raised them aggressively. But after the euro slid against the dollar, ECB officials quickly reversed course over fears of imported inflation from goods like energy that are invoiced in dollars.
The challenge now is the opposite. Fed officials have signaled that they will pause raising rates at their June policy meeting to see if the 5 percentage point increase since early 2022 significantly slows the U.S. economy. That might make it harder for their European counterparts to raise rates a few days later, despite stubbornly high inflation.
“The dollar does play a dominant role in the global economy,” said Maurice Obstfeld, a former chief economist of the International Monetary Fund. “The rhetoric coming from the ECB [last year] indicated concern about the exchange rate.”
Talk of the dollar losing its reserve currency status has risen with moves by Saudi Arabia, China and Russia to use other currencies. That’s in response to the U.S.’s use of the dollar as weapon, such as freezing Russia’s currency reserves in response to its invasion of Ukraine. The dollar accounted for less than 60% of official foreign-exchange reserves in the second quarter of last year, down from about 72% two decades ago.
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And yet to date, the dollar has lost little of its global dominance.
SHARE YOUR THOUGHTS
What’s your outlook on the global economy? Join the conversation below.
While the U.S. accounts for around one-quarter of global output and just over 10% of global trade, roughly half of global trade is invoiced in dollars, and the greenback was involved in nearly 90% of global foreign-exchange transactions last year, a share that has changed little in 20 years, according to a December report by the Bank for International Settlements.
About half of all international debt securities and cross-border loans issued in offshore funding markets are denominated in dollars.
These linkages transmit higher U.S. interest rates to foreign economies in several ways. They draw capital out of other economies, pushing up borrowing costs and causing currencies to depreciate against the dollar. About a third of the change in U.S. money market interest rates in response to Fed tightening is passed through to equivalent German rates, according to ECB research. As the dollar rises, dollar-denominated commodities such as oil become more expensive in foreign-currency terms. In the other direction, higher rates slow U.S. growth and, eventually, demand for foreign products.
All of that means the Fed’s interest-rate increases affect Europe’s economy as much as—or even more than—they do the U.S., according to ECB research. Fed tightening between 1991 and 2019 reduced the eurozone’s industrial output, stock prices, business loans and inflation rate, and weighed on world trade outside the U.S. Conversely, the ECB’s actions have minimal impact on the U.S. economy, the research suggests.
ECB officials watch the Fed’s policy actions very closely and monitor the euro-dollar exchange rate, although they say it isn’t a policy target. “When the Fed takes the lead, others will follow without hesitation,” said Panicos Demetriades, a former ECB official who was governor of Cyprus’s central bank.
To be sure, the ECB and other overseas policy makers aren’t just following the Fed. They are doing similar things because inflation everywhere is far too high, driven by common global shocks, from the pandemic to the war in Ukraine.
“You know the currency, for instance, has an impact, any spillovers will be taken into account, but we are not Fed-dependent,” ECB President Christine Lagarde said at a news conference in early May. “We have more ground to cover, and we are not pausing.”
With its policy rate roughly 2 percentage points below that of the Fed, the ECB has space to catch up, said Obstfeld.
But whether the ECB in fact does keep tightening will depend on whether the Fed has pushed the U.S. into recession. For Europe, exports—especially to the U.S.—have been a rare source of strength as the war in Ukraine saps households’ purchasing power.
Trade in goods between the EU and the U.S. increased to $86 billion in March, up around 8% from a year earlier. America’s trade in goods with China declined by around one-quarter during the same period, to $45 billion in March, according to data from the Census Bureau.
If the U.S. falls into recession in coming months, America’s imports will likely decline, removing a vital growth crutch for Europe. Still, the dollar would likely weaken, lowering European energy prices and imported inflation. Overall, a hard U.S. landing would likely make life harder for Europeans—but potentially easier for the ECB.
“Europe in general is in a pretty precarious state…that will instill some caution in the ECB,” even if there is political pressure to bring inflation under control, said Obstfeld.
https://www.wsj.com/articles/the-do...ying-interest-rates-179f01e5?mod=hp_lead_pos4
U.S. currency remains critical to European inflation and growth
By Tom Fairless
May 28, 2023 12:01 am ET
27
The dollar has lost little of its global dominance despite some countries’ push to use other currencies. Photo: Kerem Uzel/Bloomberg News
FRANKFURT—It’s not just Americans watching anxiously to see if the Federal Reserve raises rates or the U.S. slides into recession; so are Europeans, and indeed many other countries. That’s because for all the talk of deglobalization and de-dollarization, the dollar still reigns supreme, and financial and trade ties between the U.S. and key partners are as strong as ever. In Europe’s case, they’re even stronger.
The European Central Bank tried to chart a different path from the Fed early last year, signaling it would hold rates low as the Fed raised them aggressively. But after the euro slid against the dollar, ECB officials quickly reversed course over fears of imported inflation from goods like energy that are invoiced in dollars.
The challenge now is the opposite. Fed officials have signaled that they will pause raising rates at their June policy meeting to see if the 5 percentage point increase since early 2022 significantly slows the U.S. economy. That might make it harder for their European counterparts to raise rates a few days later, despite stubbornly high inflation.
“The dollar does play a dominant role in the global economy,” said Maurice Obstfeld, a former chief economist of the International Monetary Fund. “The rhetoric coming from the ECB [last year] indicated concern about the exchange rate.”
Talk of the dollar losing its reserve currency status has risen with moves by Saudi Arabia, China and Russia to use other currencies. That’s in response to the U.S.’s use of the dollar as weapon, such as freezing Russia’s currency reserves in response to its invasion of Ukraine. The dollar accounted for less than 60% of official foreign-exchange reserves in the second quarter of last year, down from about 72% two decades ago.
Advertisement - Scroll to Continue
And yet to date, the dollar has lost little of its global dominance.
SHARE YOUR THOUGHTS
What’s your outlook on the global economy? Join the conversation below.
While the U.S. accounts for around one-quarter of global output and just over 10% of global trade, roughly half of global trade is invoiced in dollars, and the greenback was involved in nearly 90% of global foreign-exchange transactions last year, a share that has changed little in 20 years, according to a December report by the Bank for International Settlements.
About half of all international debt securities and cross-border loans issued in offshore funding markets are denominated in dollars.
These linkages transmit higher U.S. interest rates to foreign economies in several ways. They draw capital out of other economies, pushing up borrowing costs and causing currencies to depreciate against the dollar. About a third of the change in U.S. money market interest rates in response to Fed tightening is passed through to equivalent German rates, according to ECB research. As the dollar rises, dollar-denominated commodities such as oil become more expensive in foreign-currency terms. In the other direction, higher rates slow U.S. growth and, eventually, demand for foreign products.
All of that means the Fed’s interest-rate increases affect Europe’s economy as much as—or even more than—they do the U.S., according to ECB research. Fed tightening between 1991 and 2019 reduced the eurozone’s industrial output, stock prices, business loans and inflation rate, and weighed on world trade outside the U.S. Conversely, the ECB’s actions have minimal impact on the U.S. economy, the research suggests.
ECB officials watch the Fed’s policy actions very closely and monitor the euro-dollar exchange rate, although they say it isn’t a policy target. “When the Fed takes the lead, others will follow without hesitation,” said Panicos Demetriades, a former ECB official who was governor of Cyprus’s central bank.
To be sure, the ECB and other overseas policy makers aren’t just following the Fed. They are doing similar things because inflation everywhere is far too high, driven by common global shocks, from the pandemic to the war in Ukraine.
“You know the currency, for instance, has an impact, any spillovers will be taken into account, but we are not Fed-dependent,” ECB President Christine Lagarde said at a news conference in early May. “We have more ground to cover, and we are not pausing.”
With its policy rate roughly 2 percentage points below that of the Fed, the ECB has space to catch up, said Obstfeld.
But whether the ECB in fact does keep tightening will depend on whether the Fed has pushed the U.S. into recession. For Europe, exports—especially to the U.S.—have been a rare source of strength as the war in Ukraine saps households’ purchasing power.
Trade in goods between the EU and the U.S. increased to $86 billion in March, up around 8% from a year earlier. America’s trade in goods with China declined by around one-quarter during the same period, to $45 billion in March, according to data from the Census Bureau.
If the U.S. falls into recession in coming months, America’s imports will likely decline, removing a vital growth crutch for Europe. Still, the dollar would likely weaken, lowering European energy prices and imported inflation. Overall, a hard U.S. landing would likely make life harder for Europeans—but potentially easier for the ECB.
“Europe in general is in a pretty precarious state…that will instill some caution in the ECB,” even if there is political pressure to bring inflation under control, said Obstfeld.
https://www.wsj.com/articles/the-do...ying-interest-rates-179f01e5?mod=hp_lead_pos4
