- We expect that the current US dollar rally will have a moderate effect on the US economy in the coming quarters. The rally has not been significant so far, compared to previous bull runs enjoyed by the dollar.
- As in the past the USD appreciation will result in a widening of the trade deficit, but this time it will be modest. The impact on US GDP growth will be around 0.5 ppts within a year. Much of this has already been assumed in our base scenario. We expect the appreciation will strip 0.3 ppts off growth this year.
- The US dollar appreciation should not exert strong downward pressure on prices, as the pass-through to consumer prices is not strong in the US.
Drivers of the USD rally…
Compared to other major currencies, the USD has been advancing steadily so far this year, with the euro/USD appreciation showing the fastest pace. There are two major factors pushing up the US dollar: signs that US recovery is firming and weaker economic performance in other countries. Indeed, the US labour market has been improving steadily. The average increase in payrolls this year has been 226K, compared to an already sturdy 190K last year. Fixed investment is leading the recovery and is reporting the fastest growth since the fourth quarter of 2011. The housing market is slowly mending. Bad mortgage debts have been cleaned out from banks. At the same time, just when the US recovery is shifting up a gear there has been some signs of cooling down in China and lower than expected growth in Japan, while fears of new stagnation in the eurozone are gaining ground.
…to stay for a while
The divergent fortunes of the US economy vis-à-vis other economies are visible in the different central bank strategies and expectations of future monetary policies. While the US is ending its asset purchase tapering programme and has announced a framework for an exit strategy for monetary easing, the ECB and the BoJ are moving towards further monetary stimulus. Diverging monetary policies are increasingly important for currency markets. For a range of economies, including advanced economies, US interest rate spreads have increased lately, supporting the dollar’s appeal. Looking forward, we expect US GDP growth to be above trend in 2014 and 2015, while it will take some time for most major economies, including the eurozone, Japan and other emerging economies to show stronger growth. This suggests that in the coming months the USD’s rally will continue.
The upside and downside of a stronger USD
On the upside and in normal circumstances, a strong dollar means that with the same dollar one can buy more of a foreign country’s goods and services. This can be beneficial for US importers and US travellers going abroad. On the downside, US exporters may suffer because relative to the weaker currency US products and services become more expensive. To understand the impact of a stronger dollar it is necessary to look at the trade weighted value of the US dollar, one of the metrics which compares the exchange rate of a country against that of its major trading partners. It has appreciated modestly, increasing by 6% since the end of 2013 and 11% since end-2012. In fact, on a weighted average, there have been two periods of large swings in the price of the US dollar: in the beginning of the 1980s and between 1995 and 2003. In the first episode the USD rose by 54% and in the second episode it rose by 40%. In 1980-85 the current account deficit widened from a balanced position to around 3.1% of GDP. Meanwhile, in 1995, the current account deficit was 1.5% and it widened to 4.2% in 2002. The currency rally has been more modest so far.
Assessing the pass-through of a stronger USD
The adjustment of the trade balance to the USD appreciation is not one on one. It will depend on the starting point of the economy and on the industry’s practices to adjust to a stronger currency, including currency trading and hedging. In fact, several studies point to a weak pass-through in the US compared to other countries. There are several factors that influence the exchange rate pass-through.
On the export side, given that importers of US goods and services have to pay more local currency to make up for the dollar appreciation, a response could be that importers/ foreign consumers demand less US exports. This loss of competitiveness of US exporting firms could encourage these firms to adjust prices at the cost of their own profit margins. In the US about 40% of firm’s revenues come from abroad according to the S&P Dow Jones indexes. Depending on the industry, some will be more prone to this action than others.
On the import side, a stronger dollar results in lower import prices. Depending on the good, demand increases or the gains from lower prices could be used to import other goods. In practice, an appreciation of the dollar has usually been followed by an increase in the volume of imports that is larger than the decline in import prices. Meanwhile in the case of exports, there is a decline in terms of volume and prices that has led to a significant fall in the dollar value of the exports. All in all this has resulted in a widening of the trade deficit.
Impact for US trade balance modest…
We are not particularly concerned about the current US dollar rally and its impact for the US under our base scenario. To begin with the US is a fairly closed economy with domestic consumption accounting for the lion’s share of GDP. Secondly, the rally of the US dollar so far has not been significant compared to previous bull runs enjoyed by the dollar. Finally, the pass-through of exchange rate adjustments is low in the US, but varies across industries. Indeed, estimates from the IMF suggest that in the United States the pass-through to import and export prices is one of the lowest compared to other countries. After one quarter, a one per cent change in the exchange rate, results in a pass-through coefficient of 0.38, for import prices and 0.17 for export prices. After one year, according to the IMF, the impact of the pass-through for import prices tends to fall. Therefore, we don’t expect expenditure to shift on account of price changes in the coming months. Meanwhile, a 1% appreciation will reduce export volumes by 0.4%, while import volumes would be boosted by 0.17%. Exports account for around 13.0% of GDP in the US, while imports are around 16.0% of GDP.
Back of the envelop calculations suggest that a 1% appreciation will reduce GDP by around 0.05 ppts via lower exports, meanwhile imports would reduce GDP by around 0.03 ppts, with the largest effect occurring within the first quarter and declining within the year. The appreciation of the USD, on a trade weighted basis is a bit more than 4% in 2014, so the impact on GDP this year would be around 0.3ppts. We expect this index to rise further to 6% this year, which means that the impact would be around 0.5 ppts over one year.
…as well as for inflation
Meanwhile, although theoretically a strong dollar should push down inflation by directly lowering the prices of imports, there is evidence that suggests that this pass-through channel in the US is not strong either. According to Fed research, the pass-through from a strong dollar to non-petroleum import prices is about -0.5 over the past five years. The relationship between import prices and consumer good prices is even weaker and has shown little common movement. The study concludes that global inflation is, however, a useful predictor of US inflation despite the weak measureable pass-through . Fed policymakers have mentioned that there are downside risks to inflation in their recent FOMC minutes. The Fed’s inflation target is 2%, but inflation expectations have been trending downwards, partly as a result of faster than anticipated decline in oil prices. On the other hand, the US will continue growing above trend and labour market slack will continue declining. This will likely push up wage growth. Overall, we maintain our forecast of a first rate hike in June next year.
Global economy effects mixed
Looking at the positive effects of a strong USD, economies exporting goods and services to the US are able to sell more products to the US, while the US is able to boost consumption. The rally of the USD vs the euro is already leading to gains in the growth of US imports from the eurozone, while imports from Japan despite the rally USD/JPY continue to be suppressed since 2012, suggesting that structural issues are behind the weaker imports. Japan’s automakers are, for instance, expanding their auto production overseas, resulting in weaker auto imports by the US. In the case of emerging markets the effects of a stronger dollar will be mixed. Although importers in Latin America and emerging Asia will likely benefit from a stronger dollar, the prospects of higher interest rates in the US will affect those emerging markets with high external debt levels, particularly those that have still high short-term debt. Turkey and Malaysia remain the most fragile in this case.