DESMOND LACHMAN: The dollar is almighty and its day of reckoning far into the future

So much for those calling for the dollar’s imminent decline because of the US’s poor public finances and wide trade deficit. Over the past month, far from falling, the dollar has scaled heights not experienced in the last 20 years.

This is good news for the US Federal Reserve (Fed) in its efforts to regain control over inflation, in that a strong dollar reduces US import costs. However, it is bad news for emerging-market economies in their fight against inflation since it increases their import costs. A strong dollar also has the effect of increasing the burden of servicing dollar-denominated borrowing.

While the future course of the dollar is notoriously difficult to predict, there is good reason to believe it will stay well bid for the foreseeable future.

This will either be because US interest rates stay high as the Fed continues its inflation fight and the US treasury has to issue large quantities of bonds to fund its gaping budget deficit, or the dollar will rise further as high interest rates cause something to break in the financial markets. It would do so as investors across the world flee to the dollar as a safe haven in troubled economic times.

The bottom line is that emerging-market economies will have to get used to living with a strong dollar for the foreseeable future.

There can be no gainsaying that US public finances are in trouble. At a time when US unemployment is close to a postwar low and the economy is operating at close to its potential, the country has a budget deficit of 8% of GDP.

As the nonpartisan Congressional Budget Office keeps warning, such a large deficit at a time of full employment puts the country’s public debt level on an unsustainable path. Little wonder then that the credit rating agencies are contemplating using political dysfunction in Washington as an excuse to downgrade US government debt.

Despite the dark cloud that the dismal US public finances cast over the dollar’s long-run outlook, they contribute to the dollar’s short-term strength by requiring the Fed to keep interest rates high for longer to reduce inflation. That induces capital to flow to the US in search of better returns than can be obtained elsewhere.

A further factor keeping the dollar well bid is the relative strength of its economy. At a time when the US economy continues to grow at a reasonable pace, the Chinese economy — the world’s second-largest — is experiencing its slowest growth in decades. This comes in the wake of its outsized housing and credit market bubble’s burst.

Meanwhile, Germany, Europe’s largest economy, has already experienced three consecutive quarters of negative economic growth. With the European Central Bank continuing to raise interest rates at a time of economic weakness, there is every prospect that the rest of the eurozone will follow Germany into recession.

There is reason to believe that the rapid rate of increase in US interest rates could be setting us up for another US and world financial crisis. The sharp rise in US government bond yields and the corresponding plunge in bond prices are causing large mark-to-market losses on US banks’ balances. Earlier in 2023 such losses caused the second- and third-largest bank failures on record at Silicon Valley Bank and First Republic Bank.

Compounding matters for the banks is that in addition to the usual credit losses associated with a rapid Fed tightening cycle the banks are likely to experience large losses on their commercial real estate loans. With occupancy rates low in a post-Covid world and interest rates high, it is difficult to see how property developers will be able to roll over the $500bn in property loans that mature in 2024.

Should something break in the financial system we can expect the Fed to do an abrupt U-turn and ease monetary policy aggressively. However, while that may cause interest rates to fall it is unlikely to cause dollar weakening. On the contrary, the dollar could be buoyed yet again by a wave of foreign capital seeking the depth of US financial markets as a safe haven in a time of world financial market turbulence.

All of this does not mean the dollar will avoid a day of reckoning as a result of the country’s chronically shaky public finances. It is to say that the day of reckoning for the dollar will not be anytime soon.

• Lachman, a former deputy director in the IMF’s policy development & review department and chief emerging-market economic strategist at Salomon Smith Barney, is a senior fellow of the American Enterprise Institute.