The strong dollar and the war in Ukraine

Exchange rate

Exchange rate

By Michael Klein·June 1, 2022

Fletcher School, Tufts University

The problem:

The dollar has strengthened over the past year, with the fastest rate of increase since the Russian invasion of Ukraine. The DXY index, a weighted average of the value of the dollar against the six major currencies, hit a 20-year high in mid-May, having appreciated 9% since February 24. Many economists predict that the dollar will reach parity with the euro by the end of the year, a value not seen since 2002. How has the war in Ukraine contributed to a stronger dollar and what are the consequences of this assessment?

The value of the dollar against the six major currencies hit a 20-year high in mid-May.


  • Over the past year, the dollar has risen 12% against the euro, 9% against the pound and 16% against the yen. During the first year of the pandemic, the dollar weakened against the euro, the pound and the yen (represented by weaker values ​​of the indices). But the trend reversed in 2021 and the appreciation of the dollar against these currencies accelerated after the Russian invasion of Ukraine on February 24, 2022. Just in the three months between the start of the invasion and at the end of May 2021, the dollar appreciated by 7.0% against the pound sterling, by 5.6% against the euro and by 10.8% against the Japanese yen (see chart) . To put that into context, these three-month changes would translate to annual appreciation rates of 31%, 25%, and 50%, respectively, if they were to continue for an entire year.
  • Exchange rates reflect countries’ relative demand for assets and respond to both current economic conditions and expectations of future conditions. The attractiveness of any financial asset is related to its expected future payment, its reliability and the ease with which it can be bought or sold. An increase in demand for a country’s assets increases the demand for that country’s currency, which is needed to purchase those assets, causing that country’s currency to appreciate (strengthen). An increase in the interest rates offered by a country’s bonds, or the expected future return of a country’s stock, increases demand for that country’s currency, leading to appreciation. Similarly, a country’s currency will appreciate if demand for its assets increases due to the perception that these assets provide a “safe harbor” in times of heightened uncertainty. Therefore, the current value of the exchange rate reflects investors’ future prospects as well as current economic conditions.
  • One of the reasons for the strength of the dollar is that US assets are considered a safe haven. United States assets, particularly treasury bills, are considered to retain value during turbulent market times and are also valued because the markets for these assets are deep and reliable. This generally leads to an appreciation of the dollar during times of global turmoil as demand for these assets increases. The strengthening of the dollar following the invasion of Ukraine is one example, but there are others as well. Perhaps most strikingly, the DXY dollar index appreciated more than 10% in the two months since the start of the global financial crisis in September 2008, despite the fact that the crisis began by a seizure of the financial markets in the United States.
  • Another reason for the dollar’s rise is the perception that the war will have relatively less negative effects on the US economy compared to those in the Eurozone, UK and Japan. While rising energy and food prices due to the Russian invasion of Ukraine are expected to have adverse effects around the world, Europe (including the UK) and Japan are expected to be hit harder than the United States. A relatively stronger economy in the United States increases the demand for American assets, as these will be less affected than assets from other countries, leading to a stronger dollar. An IMF blog from March 2022 lays out a few reasons; Russia is a key source of natural gas for Europe, the Japanese economy is relatively more vulnerable than the United States to rising commodity prices and weaker demand in its export markets, and the United States has few direct ties to Ukraine and Russia. The lower relative vulnerability of the US economy to the war in Ukraine is also reflected in revisions to GDP growth forecasts. The Wall Street Journal’s consensus forecast for growth in the fourth quarter of 2022 has been revised down from 3.3% in the January survey to 2.6% in the April survey. This drop of 0.7 percentage point is lower than the revision of the growth rates for the euro zone, the United Kingdom and Japan; the European Commission has revised its forecast for real GDP growth in 2022 from 4.0% in its winter 2022 report to 2.7% in its spring report, Price Waterhouse Coopers (PWC) has revised its growth forecast UK economic growth for 2022 from 4.5% to a range between 2.8-3.8%, and the International Monetary Fund has lowered its forecast for Japan’s economic growth for 2022 from 3.3% to 2.4%.
  • The strength of the dollar is also the result of the Federal Reserve reacting more aggressively to rising inflation compared to the Bank of Japan, the European Central Bank and the Bank of England. Rising commodity and fuel prices due to the war in Ukraine contributed to the rise in inflation that had begun as economies recovered from the initial pandemic lockdowns. Central banks fight higher inflation by raising interest rates, which contributes to an appreciation of their currency. The federal funds rate fell from 0.08% in February to a current range of between 0.75% and 1%. The Federal Reserve has raised its target rate at each of its last two meetings, with the 50 basis point hike in May 2022 being the biggest one-time hike since 2000. And those hikes are expected to continue. After the May 4 meeting, Chairman Jerome Powell said, “There is a general feeling within the committee that additional increases of 50 basis points should be on the table at the next two meetings.” By contrast, the UK Bank Rate has risen 50 basis points since February, but the Monetary Policy Committee appeared to temper its desire to continue aggressively raising interest rates at its meeting on May 5, 2022, in a backdrop of concerns about the slowdown in the UK economy. Until May, European Central Bank President Christine Lagarde had said the ECB would only start raising interest rates in July and that any further hikes would be gradual. But in the face of rising inflation, she indicated in late May that the European Central Bank would raise interest rates from negative values, where they had been for eight years, to zero by the end of September and could continue to rise. rates after that, which strengthened the euro. at its highest level in a month against the dollar. In late May, Bank of Japan Governor Haruhiko Kuroda told a parliamentary committee that as Japan’s economy was still recovering from the pandemic, the Bank of Japan would “patiently pursue powerful monetary easing.”
  • What does the appreciation of the dollar mean for American consumers and American producers? The exchange rate translates the price of goods denominated in one currency into a price in the currency of another country. The strong dollar drives up the price of US goods abroad, putting downward pressure on US exports. At the same time, a stronger dollar lowers the price of imported goods in the United States, which increases imports. In fact, the US trade deficit hit a record $109.8 billion in March 2022, up more than 20% from its February value. Although the strength of the dollar over the past year plays a role in this figure, it is important to note that there is no immediate link between the exchange rate and the trade deficit. The exchange rate is a factor affecting the relative prices of goods between countries, but higher inflation in one country than in its trading partners will also increase the relative price of its goods. Additionally, since international trade contracts are signed months before delivery, changes in exchange rates take time to trickle down to the trade account. Finally, imports and exports depend on factors other than the exchange rate, such as the growth of the income of the national economy (for imports) or of the income of trading partners (for exports). So while the recent sharp appreciation of the dollar may contribute to future trade deficits, the March figure is unlikely to be directly related to the immediate appreciation of the dollar following the invasion of Ukraine.
  • The strength of the dollar has a whole range of effects on economies around the world. Commodities like oil and wheat are quoted in dollars. The effect of an increase in the dollar price of these commodities is exacerbated for countries whose currency has lost value against the dollar. Low-income countries and emerging markets will be particularly affected by a strong dollar. Along with rising food and fuel prices, many of these countries have borrowed in dollars, and repaying those loans becomes more expensive as the dollar strengthens. Mohammed El-Erian, former chief economist of Pimco, wrote in the Financial Times “For the most part [low-income countries], the appreciation of the dollar translates into higher import prices, more costly external debt servicing and an increased risk of financial instability. This puts additional pressure on countries that have already exhausted their resources and policy responses by battling the Covid ravages of their dollar-denominated debt. »

Along with the more obvious economic effects of the Russian invasion of Ukraine, such as energy prices and food prices, there has also been a strengthening of the dollar. There have not yet been calls for government efforts to weaken the dollar, perhaps because these efforts often prove futile and represent an example of “the tail wagging the dog” in which the main variables concerns, such as inflation and growth, are set aside. Nevertheless, the strength of the dollar will have important consequences.

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