Wednesday 28 September 2022
A big difference with the 1970s: the US dollar
With the return of inflation to its highest levels for forty years in the developed countries, there are obviously many analogies made with the 1970s. Some are quite relevant (shock on the price of energy, shortages of all kinds) but there is one point which differs completely between the current energy crisis and that of the 1970s: the reaction of the US dollar, which strongly appreciated over the last quarters.
The energy crisis is a major shock for some countries
For energy importing (respectively exporting) countries, the sharp rise in the prices of natural gas, oil and gasoline has greatly increased imports (resp. has caused a sharp increase in exports). For example, after accumulating large trade surpluses for years, the euro zone is now accumulating spectacular trade deficits (more than €40 billion in July).
This evolution of the energy commodity prices has repercussions on the foreign exchange market because the "terms of trade" (i.e. the ratio of export prices to import prices) is a fundamental determinant of exchange rates over the long term (with, among other things, productivity, net foreign assets). For countries that are net importers (respectively net exporters) of energy commodities, there is a negative (resp. positive) shock on the terms of trade, which has negatively (resp. positively) affected their currencies.
We could see in mid-June that the very sharp drop in Russian gas deliveries via the Nordstream 1 gas pipeline coincided with a sharp depreciation of the euro against the dollar, the explanation being that the sharp rise in the price of natural gas has increased Europe's energy bill a little more and greatly deteriorated the terms of trade.
The oil shocks of the 1970s had caused a fall in the US dollar
In the 1970s, the two oil shocks led to a very sharp deterioration in the terms of trade for the United States, which was then a major oil importer, but also an importer of natural gas. This had had a very negative effect on the US dollar: in the first months of 1974 and following the first sharp rise in energy prices, the real effective exchange rate of the United States had thus lost more than 5%. During the oil shock of 1979, the US dollar was in a phase of appreciation because the Fed had initiated under William Willer (just before the arrival of Paul Volcker) a very vigorous monetary tightening: the fed funds were above 10% at the end of 1978, versus 6.75% in March 1978 when Miller arrived, and above all well above European or Japanese interest rates. It is therefore not forbidden to think that the good performance of the US dollar in 1979 despite the rise in oil prices can be explained by the already very offensive monetary policy of the Fed, compared to the other major central banks.
The current situation is very different in this regard because the terms of trade for the United States improved significantly during the energy crisis of 2021/2022, unlike what happened in the 1970s. The reason for this is that the United States has recently become a net exporter of natural gas and petroleum products. The sharp rise in natural gas prices has thus greatly improved the terms of trade for the United States, unlike what happened for Europe and Japan. While the energy crisis of the 1970s had been negative for the US dollar, the energy crisis of 2021/2022 is positive for the US dollar. This is one of the main causes of the appreciation of the US dollar in recent quarters.
Another cause of US dollar appreciation relates to monetary policy. Indeed, the Fed has tightened its monetary policy much more vigorously and much earlier than the other major central banks in 2022. It has raised its key rates by 300 basis points since the start of the year and has initiated a policy of significant reduction in its balance sheet. The other major central banks have done much less:
- The ECB has raised its key rates by 125 basis points and has not yet started reducing its balance sheet,
- The BoJ kept its key rates unchanged and continued to buy assets,
- The PBoC cut rates.
This major monetary policy gap, reminiscent of that of 1979, helped to strengthen the US dollar: the real effective exchange rate of the United States thus returned to its highest level since 1985. The USD/JPY parity is at its highest high level since the early 1990s and the USD/CNY parity is no longer very far from its highest levels since 2008.
This very strong appreciation of the US dollar is becoming problematic for a large number of countries, either because they are indebted in dollars, or because they are net importers of commodities invoiced in dollars. Some have engaged in a “reverse currency war”, by rapidly liquidating part of their foreign exchange reserves to curb/limit the depreciation of their currencies or by rapidly raising their key rates. Over the first 7 months of June, the foreign exchange reserves of emerging countries excluding China fell by more than $500 billion, an even faster rate than during the 2008 financial crisis.
While the current energy crisis evokes many analogies with that of the 1970s, a notable difference concerns the behavior of the US dollar, which has appreciated very strongly this year. Indeed, the United States are now net exporters of natural gas and petroleum products whereas they were net importers in the 1970s. This is a positive shock for the terms of trade of the United States but negative for Europe, the United Kingdom, Japan but also China. The dollar is also appreciating due to the aggressive monetary policy against the three other central banks in the world (ECB, BoJ and PBoC). This brutal appreciation of the US dollar will weigh on the American economy but will also constitute a problem for a certain number of other countries, either because they are indebted in dollars, or because they are net importers of commodities invoiced in dollars. New Plaza agreements are beginning to be discussed: it is not impossible but the subject does not yet seem to be a priority for global leaders.
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Bastien Drut, Chief Thematic Macro Strategist