Massive rise in the US dollar could help solve inflation puzzle

One of the least commented upon results of the massive spike in world inflation has been the remarkable rise in the US dollar.

Floating currencies can act like giant shock absorbers for economic jolts, and in this case, the rise and rise of the US dollar is playing a massive role in rebalancing inflation lower.

With the US dollar index now retreating a little from a three-decade high, the full extent of the effect on the US inflation should become apparent over the next few months.

One implication of the higher US currency is that imports – even highly priced ones like fuel – become more reasonable in US dollar terms.

The counter effect is that US exports go up in price and become less competitive on world markets.

Higher dollar battles imported inflation

However, with much of the big spike in US inflation effectively imported through higher fuel prices and other commodities, that loss of international competitiveness won’t matter as much because of the anti-inflationary impact of a higher dollar.

There are possibly several things at play for the rise of the US dollar – it is a currency that always attracts inflows as a safe haven during harsh economic times and higher interest rates will also be attracting money seeking high, risk-free returns.

Some of the dollar strength is also caused by harder times being faced by other big players on the world scene.

European gas shortage leading to a grim winter

With big disruptions in the supply of gas from Russia to Europe, the US dollar has climbed to record highs against the UK pound and has also traded above one-for-one against the Euro.

While you can expect to see those rates bounce around with every development in the war in Ukraine, with a potentially energy short winter approaching in Europe it is hard to see much of a recovery in the Euro and pound in the short-term.

Europe is coming closer to energy rationing that could crimp its industrial production, not to mention causing severe inflation of energy prices that will pass through as a second round of price rises all around.

Already European inflation is higher than that in the US at 9.1% compared to 8.5%, with US inflation also showing signs of easing a little.

That is why the Eurozone central bank pushed interest rates up 0.75% last week to 1.25% despite recession fears as it tries to get ahead of price rises.

Growth in Europe, developing world could turn negative

Eventually, that might strengthen the Euro but only at the expense of already tepid European economic growth, which could easily turn negative.

It is a similar but perhaps more extreme scene in the developing world, which is hurting due to the rising US dollar.

Here in Australia the effect of a high US currency is probably more muted, although it may make getting inflation under control here more difficult.

On the export side, Australia is doing reasonably well with the fairly large caveat that our major trading partner – China – is hitting plenty of trouble as it continues to use lockdowns to choke off COVID cases.

Australia hostage to Chinese growth

Economic weakness in China inevitably leads to lower prices and volumes of Australia’s exports there – particularly iron ore.

China, too has seen its currency take a hit compared to the US dollar, although it has performed better against the Australian dollar.

While a stronger US dollar could be an important tool in reigning in US inflation and reducing the need for further interest rate rises there, it also raises the spectre of reinforcing economic weakness in other areas including China, Europe and the developing world, with obvious kick-on effects for Australia.

This makes keeping a close eye on currency a must for all investors as their movements are a harbinger of how the global inflation rise will be resolved and whether recessions start to feature around the world.