A March 25th report from Morgan Stanley Global Research includes an article titled The Dollar Tantrum by Manoj Pradhan. In the article, Pradhan highlights three results of the stronger dollar: it’s “reflating” the global economic system, it’s creating a more internationally focused Fed and it’s making it much more likely that emerging markets will face major headwinds, especially if the dollar remains strong when the Fed starts to raise rates later this year.
Global economies export deflation to the U.S.
First, it is clear that a stronger U.S. dollar is helping to reflate the world and prepare for rising rates. It boils down to a stronger dollar makes it easier for other economies to export deflation to the U.S. As Pradhan points out: “In an ideal world, economies with disinflationary trends – particularly the large advanced economies – will have exported just enough deflation to the US to stabilize inflation expectations and probably growth too. This would allow the US to start the process of policy rate normalization and for growth and inflation elsewhere to be low enough.”
Stronger dollar is creating a more “international” Fed
According to Pradhan, a stronger US dollar also creates a more “international” Fed: He points out that since “currencies are relative prices that connect two economies”, large moves in foreign exchange rates “transmit shocks from one economy to the other” as they are supposed to. The current situation of weak growth abroad (especially in the euro area and Japan) and a robust dollar makes it easy to “import weakness” from abroad.
He also suggests it is quite likely that if the global economy had been in better shape today, the sharp appreciation of the dollar would have merely softened US export growth somewhat. However, it today’s demand-deficient world, the downside risk to already weak export growth has come to roost much sooner. By the same token, inflation is also weakening faster “as even the domestically generated components of inflation have shown downside over the last few months (the imported ones have been deflating for quite a while now).”
Potential for “dollar rage”
Pradhan highlights that Morgan Stanley’s FX forecasts project that the dollar still has some room to run, but that the strengthening cycle is more than half way run. He points out the current situation EMs being buffered by a depreciating currency will not last forever, and that the combination of a strong dollar and U.S. rate hikes could cause significant turmoil in emerging markets.
“However, there may be a time, as we get closer to the Fed raising rates (which should also see more stability in the euro area and Japan), when both US rates and the dollar could rise at the same time. This might be enough to turn a ‘dollar tantrum’ into a ‘dollar rage’.