On July 14, the Euro slid below the U.S. dollar for the first time in 20 years. The Euro’s downward spiral has been swift and brutal, given that it was trading around $1.15 in February.
As the world’s most important currency, the dollar often rises in times of turmoil, in part because investors consider it to be relatively safe and stable. A string of increasingly large Federal Reserve interest-rate hikes has supercharged the dollar. Cash tends to gravitate to economies that offer a combination of growth prospects and higher interest rates. An increased demand for dollar-denominated securities boosts the value of the dollar.
We need to recognize that big moves in currencies undermine business confidence. It can lead to economic and financial instability. A weak Euro drives up the cost of imports, exacerbates Europe’s already high inflation rate, and makes Europe’s exports cheaper.
The weakness in the Euro relative to the United States dollar is primarily attributable to two major issues.
First, recession risks are high in Europe, where the inflation-induced cost-of-living crisis is coupled with possible gas shortages. Russia’s invasion of Ukraine has caused more problems for Europe than America because Europe is heavily dependent on Russian oil and gas. Second, European interest rates are unattractive relative to the United States because their current emphasis is on preventing a recession rather than fighting inflation. The European Central Bank (ECB) has not yet increased the official deposit rate from its current negative 50 basis points.
On July 11, Russia shut off natural gas in the Nord Stream 1 pipeline for “scheduled maintenance work.” The pipeline carries 55 billion cubic meters of natural gas each year from Russia to Western Europe. European officials fear that the pipeline will not be turned on again to punish them for backing Ukraine and embracing Western sanctions in response to Russia’s invasion. Losing Russian gas supplies would plunge the region into a severe recession.
The second major reason for the Euro’s weakness is overnight rates in Europe are almost 2% below the U.S. Despite Europe’s high inflation rate (8.6% in June), it is unlikely that the ECB can raise rates high enough to solve this issue. Raising rates is harder for the ECB than other central banks because the borrowing costs of more indebted euro-area nations (Greece, Italy, and Spain) could spiral out of control if investors begin to question their ability to fund their debt loads.
The strong dollar tends to put downward pressure on commodity prices, which are denominated in dollars. Oil, copper, and agricultural commodities have all slid as the dollar increased. It also provides some relief from inflation because of the vast array of goods that we import.
On the negative side, a strong dollar hurts American companies because our goods become more expensive for foreign buyers.
Mark Zandi, chief economist of Moody’s Analytics, wrote that “the stronger dollar weighs on (U.S.) economic growth as it results in reduced exports, more imports, and thus a wider trade deficit.” In May 2022, the U.S. trade deficit was $85.5 billion.
Investors are pouring into dollars because they believe that our economy will be stronger, and our interest rates will remain higher than those of Europe. Currently, because the Federal Reserve and the ECB have different priorities, there is a high likelihood the dollar will remain strong relative to the Euro. Federal Reserve Chairman Jerome Powell wants to raise interest rates aggressively because he believes that the biggest risk to the U.S. economy is persistent inflation. By contrast, the ECB is reluctant to raise their interest rates. They are more focused on fighting a probable deep recession caused by an energy shortage than subduing inflation.
Originally published in the Sarasota Herald-Tribune
