Why did the USD rise in 2022, even though the U.S. spent the most money?
The U.S. dollar has been gaining against all currencies in 2022. The U.S. dollar index rose to 114.1 on 27 September 2022, beating all previous estimates. It eventually settled down to 113 and hovered around that value.[1]
The U.S. government wants to control rising inflation, and its monetary policies have caused the dollar to gain value. Several reasons led to this point.
The U.S. is facing one of the worst inflation due to oversupplying and spending of the U.S. dollars[edit]
In the last few decades, the U.S. Federal Reserve (Fed in short) has bought government debt and turned them into bonds by printing money that does not exist. While it does that, the return rate on those bonds keeps falling, and they have touched zero in the last few years.
This mechanism is called quantitative easing. It spurs growth and stokes inflation because people spend more money due to easy access to cash in the market due to government spending and lending. When people spend more money and consume rapidly, the prices of goods also increase due to the finite supply of everything.[2]
The U.S. economy was stalling during the pandemic, and one way they chose to keep the economy afloat was through the growth of dollar supply to the market. In simpler terms, the U.S. Fed's fiscal and monetary decision to counter the ill effects of the pandemic was to print more U.S. dollars at will and buy government debt.[3]
The oversupply of U.S. dollars resulted in a dilution of the purchasing power of the currency. This oversupply also resulted in the consumer index leaping from 1.4% to 9.1% in January 2021 in a small duration of 12 months. It took 12 years for the last recorded climb on the consumer index of such magnitude in the 1970s.[4]
The fiscally responsible way to counter inflation was to control the supply of U.S. dollars, even if it may have unwanted side effects of the recession.[5]
The Russia-Ukraine conflict exacerbated the inflation globally and strengthened the U.S. dollar[edit]
The Russia and Ukraine conflict that began in early 2022 has hugely impacted commodity prices globally. Russian and Ukrainian commodity exports account for around a quarter of the world wheat supply. Russian energy exports have also been disrupted due to Western sanctions on Russia, causing fuel prices to rise.[6]
The ongoing core inflation rapidly spiraled into headline inflation because of rising wheat and energy prices. The U.S. was significantly affected, resulting in an unprecedented rise in the cost of living in America.
Investors also seek U.S. dollars as a safe asset during times of volatility that result from unforeseen situations such as wars. These investments have increased the value of the U.S. dollar.
The Fed hiked short-term rates to counter the inflation, resulting in a stronger U.S. dollar[edit]
By purchasing and holding the majority of U.S. government debt and securities, the Fed decreases the overall market supply of these instruments. Retail investors who want to buy and hold these assets will bid for the remaining debt bonds reducing its yield. This impact is known as "portfolio balance." This technique is especially significant during times of crisis like the COVID pandemic when the Fed prints the U.S. dollars to buy debt for the long term. The long-term interest rates remain above this effective lower bound even when short-term interest may fall to zero, allowing more room for economic stimulation by purchasing the debt.
The private sector uses these treasury yields as a benchmark for deciding the lending interest rates and corporate bond interest yields. With low-interest rates, households are more likely to obtain mortgage or auto loans, and businesses are more likely to invest in equipment and hire employees. Lower interest rates are associated with higher asset prices, increasing households' wealth and consequently stimulating spending. [7]
This spending cycle spurred by the Fed's long-term purchase of government debt is the primary reason for inflation in the U.S. economy.
U.S. Fed did an aggressive rate hike of 2.36 percentage points between March and September 2022. The Fed took this action to counter the rising inflation, which may have climbed into the double digits if left unchecked. The Fed's updated predictions indicate that its policy rate may rise to 4.4% by the end of 2022 before topping at 4.6% in 2023, and there will not be any respite until 2024.[8]
These decisions have resulted in a 14% gain in the value of the U.S. dollar in a matter of months.
There are several downsides to rising dollar value[9]:
- A strong dollar is not suitable for companies remitting their profits back to the country.
- The investors would choose to remit their investments out of the U.S. to benefit from the strong dollar.
- It will restrict the money supply at a cheaper rate of interest to businesses and the market resulting in a slowdown of the U.S. economy.
References[edit]
- ↑ "DXY | U.S. Dollar Index (DXY) Overview". MarketWatch. Retrieved 2022-10-17.
- ↑ Inflation = Money Spent ÷ Goods Sold, retrieved 2022-10-17
- ↑ "How the Fed Bond Binge Predictably Stoked Inflation". Council on Foreign Relations. Retrieved 2022-10-17.
- ↑ University, Stanford (2022-09-06). "What causes inflation?". Stanford News. Retrieved 2022-10-17.
- ↑ "Bloomberg - Are you a robot?". www.bloomberg.com. Retrieved 2022-10-17.
- ↑ Macchiarelli, Corrado. "Ukraine War Is Driving Global Inflation. Here's How Much". www.barrons.com. Retrieved 2022-10-17.
- ↑ "Understanding the Federal Reserve Balance Sheet". Investopedia. Retrieved 2022-10-17.
- ↑ "US interest rates are rising faster than at any time in recent history. Is this creating a risk of recession?". World Economic Forum. Retrieved 2022-10-17.
- ↑ "A Powerful Dollar Could Spell Trouble for Investors". Morgan Stanley. Retrieved 2022-10-17.