Is currency intervention the answer to a soaring dollar?

by | Oct 31, 2022

In recent months the idea of a Plaza Accord 2.0 has been mentioned amongst investors and economists.

This month we explore this idea further and whether it is a viable option for policy makers this time round.

The Plaza Accord was an agreement made in 1985 between France, Germany, United States, United Kingdom, and Japan, which sought to depreciate the dollar through coordinated currency intervention. Over the next decade, the value of the dollar dropped, and the yen rose.

Times have changed a lot since 1985. For one, the Plaza Accord came after many years of managed exchange rate regimes. These days currencies are free floating. That being said, it is still worthwhile to draw comparisons between past times and the present.

The balance of payments of a country affects the value of a currency through the effect of supply and demand. The balance of payments summarizes the economic transactions of an economy with the rest of the world. These transactions include exports and imports of goods, services, and financial assets, along with transfer payments (like foreign aid). In layman terms, when a country imports more than it exports, it runs a deficit. When a country imports less than what it exports, it runs a surplus.

If a country runs a deficit, and thus imports more than it exports, there is a lower demand for its goods, and thus, for its currency. The economics of supply and demand dictate that when demand is low, prices fall, and the currency depreciates in value. Therefore, deteriorating balance of payments should be matched with a weaker currency.

Currently we see that in the US there is a clear divergence in the relationship between the balance of payments and the value of the dollar.

See Figure 1

The US basic balance (the sum of the current account balance and foreign direct investment) is deteriorating, which would warrant a depreciation in the dollar. However, the dollar is appreciating. This is like the Plaza Accord years where the dollar soared, and the trade deficit widened.

See Figure 2

This would be a factor that could warrant a currency intervention like the Plaza Accord. A Plaza Accord 2.0 would also only be feasible if inflation in the US could be contained and brought in line with target levels. In the 1980’s, the Federal Reserve’s Paul Volcker was able to bring inflation down significantly versus its peers. In the US there are signs that Federal Reserve policy may have allowed US inflation to have peaked versus its peers.

See Figure 3

The strongest case against an accord is that, although US inflation seems to be rolling over versus its peers, inflation is still far off target levels. A strong dollar generally helps reduce U.S. inflation by reducing the prices of goods and services imported into the US. It also typically curbs U.S exports by making them more expensive in global markets, slowing economic growth, which can also ease price pressures. The US Treasury Department is unlikely to want to take steps that could undercut the Federal Reserve’s efforts to tame inflation. Furthermore, while the Federal Reserve continues its path of interest rate hikes, any US foreign exchange intervention is unlikely to have a meaningful impact on the value of the dollar. Another big difference between the 1980s and today is that currently interest rate differentials support a stronger dollar, whereas interest rate differentials were moving against the dollar in the 1980s and so a stronger dollar was not warranted. If inflation in the US is not contained, the Federal Reserve will stay hawkish and continue raising rates, which will underpin a stronger dollar.

The strongest case for currency intervention would be if the appreciating dollar caused financial stress in the US and the rest of the world. The dollar’s strengthening relative to other currencies puts pressure on many other countries around the world, boosting the costs of imports priced in dollars and servicing dollar-denominated debts. This is particularly difficult for many developing economies that struggle with large debts and import much of their fuels, food, and other commodities.

A strengthening dollar poses a risk to the global economy. Central bankers around the world might feel they must raise interest rates more rapidly than anticipated to fight inflation in their own countries and to prevent further depreciation of their currencies. The tightening of global financial conditions raises the probability of a recession.

See Figure 4

Although some may feel that a currency intervention to stem the rise in the dollar is needed, the reality is that it is unlikely at this stage given the factors against intervention. For now, as US Treasury Secretary Janet Yellen has made clear, dollar value will be determined by market forces.

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