[Insight & Opinion] The Negative Impact of a Strong Dollar on the Real Economy

Kim Kyung-soo, Professor Emeritus, Department of Economics, Sungkyunkwan University

Last week, as announced, the U.S. Federal Reserve raised the policy interest rate by 0.5 percentage points. The current target range for the federal funds rate of 0.75?1% is expected to rise to over 3% and up to a maximum of 5% next year. Additionally, starting in June, the Fed also announced plans to reduce its holdings of $9 trillion in assets (Treasury bonds and mortgage-backed securities).

Among the G20 countries, only five?including Russia, Argentina, and Turkey, which are facing economic difficulties?have higher inflation than the United States. The reason U.S. inflation is so high is that during the COVID-19 pandemic crisis, the government distributed massive disaster relief funds, significantly increasing the money supply, yet the Fed overlooked inflation as a temporary phenomenon caused by supply-side factors such as production disruptions and logistics difficulties.

Although the response was delayed, the Fed’s monetary policy stance has been the most aggressive compared to other countries, accompanied by a strong dollar. The dollar index, which measures the value of the dollar against major currencies, is much higher than during the global financial crisis and is close to the level at the start of the pandemic crisis. Such high inflation and a strong dollar create unfavorable economic conditions for countries on the periphery of the global economy, including South Korea.

Meanwhile, despite the strong dollar, there are no signs of a shortage of domestic dollar liquidity. The swap basis, an indicator of dollar liquidity (the arbitrage profit foreigners earn by sourcing dollars overseas and operating domestically), remains stable, unlike during the global financial crisis and the pandemic crisis. Therefore, at this point, the strong dollar is expected to have a greater negative ripple effect on the real economy than on foreign exchange or financial sectors.

First, there is the possibility that the U.S. will export stagflation. The surge in international commodity prices, mostly quoted in dollars, is expected to raise production costs for companies measured in their local currencies, leading to reduced production activities while prices rise. Consequently, post-pandemic economic recovery is inevitably slow.

Next is the repayment burden of emerging low-income countries with large dollar-denominated external debt. If these countries are resource importers dependent on international commodities whose prices have risen sharply due to war, the risk of a balance of payments crisis increases. The IMF is already providing financial support amounting to $170 billion to 90 countries.

Third, even peripheral countries with relatively low inflation cannot avoid following the Fed’s monetary policy to maintain foreign exchange and financial stability. In these countries, interest rate hikes increase the repayment burden on heavily indebted households and companies, raising concerns about debt overhang (where excessive debt suppresses consumption and investment). Debt overhang can worsen into a balance sheet recession if excessive debt coincides with falling asset values.

Finally, there is the conflict caused by the U.S. external imbalance. In March, the U.S. trade deficit (February’s $89.8 billion) reached a staggering $109.8 billion. Moreover, despite rapid economic recovery, this record-level deficit contributed to the first quarter GDP contracting compared to the previous quarter.

The overvalued dollar, resulting from high inflation and a strong dollar, increases imports and causes excessive external deficits. If, as some experts predict, aggressive monetary policy leads to economic contraction or recession rather than a soft landing for the U.S. economy, it could trigger trade disputes. A strong dollar shrinks international trade for peripheral countries that use the dollar as a trade settlement currency, acting as a negative factor for growth. Therefore, the trade surpluses these countries have with the U.S. tend to be recessionary surpluses, which could potentially lead to a resurgence of protectionism.

Last month, the IMF forecasted that the war would have a worse impact on emerging and developing countries than on advanced economies. The Fed’s monetary policy is another risk factor not only for these countries but also for all peripheral nations.

Kyungsoo Kim, Professor Emeritus, Department of Economics, Sungkyunkwan University

This content was produced with the assistance of AI translation services.