The depreciation of the dollar was one of the market surprises of 2017, defying the predictions of many analysts and economists at the start of that year.
Continued weakness in 2018 has led some, including European officials, to warn about possible detrimental effects on growth.
They are highlighting what may be thought of as the foreign exchange markets' "hot potato" syndrome -- no one appears able or willing to navigate the growth and trade consequences of a meaningful and durable appreciation of their currency.
Although these concerns are understandable and unlikely to go away soon, significant further dollar depreciation is far from a given. Moreover, it is in the power of Europe and Japan to deal with the spillover effects of recent foreign-exchange moves, though the situation does complicate the immediate policy issues facing both the Bank of Japan and the European Central Bank.
When measured by the DXY index, the dollar's value against other currencies dropped 10 percent in 2017, with another 1.5 percent decline so far this year. These moves have confounded many analysts, especially those who focus primarily on U.S. economic and policy developments. After all, the Federal Reserve has ended up hiking rates more than the markets predicted a year ago, and the economy has grown faster than most anticipated -- outcomes that would normally lead to an appreciation of the currency.
True, a year ago, President Donald Trump warned that a greenback that is too strong would have deleterious effects on U.S. growth, trade and jobs. Those comments led to an immediate depreciation. But another contributor to the currency's surprising evolution is what has been happening abroad, including in Europe.
Led by Germany, Europe's growth performance has far surpassed expectations, leading many to bring forward the timeline for reduced monetary policy stimulus by the European Central Bank. From the French elections to the aftermath of the German vote and the Catalan referendum, politics have been less disruptive to growth and capital flows than many expected. Moreover, the likely emergence of an Emmanuel Macron-Angela Merkel partnership at the heart of the euro zone has raised hopes for bolder and more coordinated economic leadership on the continent as a whole. At the same time, a torturous process has delayed Brexit's economic and financial impact (including on the pound, which traded earlier this week against the dollar at a level not seen since before the June 2016 referendum).
Although they were surprised at first, markets have now priced in this set of European circumstances that favor the euro. Something similar has also been the case with Japan, as well as emerging countries where concerns about possible trade disruptions and debt have yielded in several cases to greater optimism about growth and financial viability. Indeed, from here, the balance of possible upside economic surprises, and the tightening of monetary policy (beyond current market expectations) that would come with that, is likely to favor the U.S. most.
This is one reason why the weaker dollar is not as much of a headwind to the synchronized global recovery as some worried it would be. Its negative growth impact would also be minimized if both Europe and Japan were to move more aggressively on overdue structural reform. Yet this will not negate the immediate challenges to central banks.
A stronger euro and yen translate to a further dampening of inflationary pressures even as both the Bank of Japan and the European Central Bank have yet to totally overcome their concerns about harmful deflation. In other words, worries about the overall low rate of inflation, or lowflation, overwhelm, at least for now, the possible distinction between good and bad causes of disinflation. This will reinforce these central banks' cautionary posture, keeping them highly data-dependent, and likely to err toward continued slow gradualism for now, notwithstanding the meaningful pick-up in actual and prospective economic growth.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."
© Copyright 2023 Bloomberg L.P. All Rights Reserved.