Dollar Aids World Economy Amid Currency War for Faster Inflation

It was four years ago last week that Brazilian Finance Minister Guido Mantega declared a “currency war” was underway as the U.S. dollar fell amid easy monetary policy from the Federal Reserve.

As the likes of Mantega prepare to jet to Washington next week for the International Monetary Fund’s annual meetings, they will likely be much happier about the dollar’s direction.

That’s because the U.S. currency, as measured by the Bloomberg Dollar Spot Index, has gained almost 7 percent since the start of July and is now around its highest in four years. Behind the rise is the U.S. economy’s outperformance against its peers and bets the Fed will be among the first major central banks to raise interest rates.

The hope of many foreign policy makers is that such a surge will provide their more lackluster economies with an inflationary fillip, be it through more exports to America or higher import prices. Of 34 economies monitored by HSBC Holdings Plc, only eight currently have inflation above their target and expectations are for that number to drop to three next year.

As they battle weak inflation, the likes of the European Central Bank and Bank of Japan have indicated they welcome weaker currencies. Bank of England policy maker Kristin Forbes said yesterday an appreciating pound had cooled U.K. inflation although its effect will fade.

Weaker Currencies

New Zealand sold the most of its currency in seven years in August and Bank of Korea Governor Lee Ju Yeol has complained the won is hurting growth. Just last week, Swiss National Bank President Thomas Jordan said he could “immediately” supplement a cap on the franc, and the Czech Republic kept a similar ceiling on its koruna.

A sustained gain in the dollar “may not be enough to push inflation back to target in those countries struggling with the deflation threat, but it could buy them time and help prevent inflation expectations becoming permanently detached from target,” HSBC currency strategists led by London-based David Bloom said in a report to clients yesterday.

Their analysis of history suggests a 20 percent climb of the dollar would not be implausible as they predict it to be the strongest major currency again next year.

What’s different from previous periods of dollar strength such as the early 1980s and late 1990s is that this episode is unlikely to be tripped up by the U.S. current-account deficit getting too big, they said. The shortfall has dropped to almost 2 percent of gross domestic product from almost 6 percent in 2006.

Currency Effects

Not all are confident. While currency effects are not as big as they once were, Michala Marcussen, global head of economics at Societe Generale SA, says commodity exporters will face a headwind from a higher dollar, and it could draw capital from elsewhere. Currency weakness elsewhere could also breed complacency among governments who should be revamping their economies, she said.

The test will be how long U.S. policy makers are willing to accept the disinflationary drag of a stronger dollar, said Bloom and colleagues at HSBC.

It’s already drawing the attention of some at the Fed, even though it would take a 20 percent rally to halve a 2 percent inflation forecast, HSBC said. The currency’s previous decline may also make it hard for the Fed to bristle at others embracing depreciations of their own.

“There is clearly a lot more room for the dollar to strengthen before it would begin to have a sizeable impact on U.S. inflation projections,” said Bloom’s team. “This is a currency war where stealing inflation rather than growth is the goal.”

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