On the round trip movement of the (king) dollar

In a year of widespread losses in the financial markets, if there is any asset that stood out for its positive performance during much of 2022, it was the US dollar. Its appreciation, in effective nominal terms, amounted to 16% in the first nine months of the year, marking the biggest advance since 2015 when the Federal Reserve ceased net bond purchases following the stormy taper tantrum episode.

The strength of the dollar last year was particularly pronounced against the euro. It closed below parity with the European single currency in 46 sessions of the year, reaching a low of 0.959 at the end of September, the lowest level since the euro’s introduction two decades ago.

However, more than this appreciation, perhaps what has surprised analysts the most is how quickly it has reversed. Between the end of September and the end of February, the dollar depreciated by 6% in effective nominal terms and by 10% against the euro, trading at close to 1.07, a level not seen for almost a year.

Given how sharp this movement has been, in this Focus we explore what lay behind the change in trend and to what extent it could continue.

To answer these questions, we begin by analysing the factors behind the appreciation of the dollar up until October 2022.

Firstly, we highlight the demand for the dollar as a safe-haven asset. In a year overshadowed by the final throes of the pandemic, and above all by Russia’s invasion of Ukraine, it is no surprise that investors, as is typical during episodes of uncertainty and volatility, opted to hedge some of the risk by increasing their «long» positions in the US currency (i.e. buying assets denominated in dollars). This factor is particularly relevant in the current context of inflationary tensions, disruptions in the commodity markets and, in particular, uncertainty regarding the energy supply.

On this latter point, the terms of external trade improved in the US, which is a net exporter of energy, compared to other major economic blocs, especially the EU. In fact, according to data from the balance of payments, the euro area closed 2022 with a negative current account balance (–0.8% of GDP versus +2.3% in 2021), making it the first year with an external deficit since 2011, at the height of the sovereign debt crisis. These factors exerted downward pressure on the euro’s exchange rate with the dollar.

The US Federal Reserve, meanwhile, has been at the forefront of the monetary tightening process among advanced economies, with cumulative official rate rises of 450 bps and with the onset of quantitative tightening even before this summer. This decisive response widened the gap between US interest rates and those of other economic blocs, both in the money markets and in the sovereign debt markets, which favoured capital inflows into this country (see second chart).

Finally, the economic recovery in the US in the post-pandemic period has been faster and stronger than in other developed countries, due to the vast rounds of fiscal stimulus approved in recent years. In the euro area, by contrast, the strong growth in 2022 as a whole reflects, on the one hand, the rebound associated with the reopening process in the first half of the year, but also, on the other hand, the slowdown and virtual stagnation seen in the second half of the year, which was dominated by the energy crisis.

• 1. The economic literature groups the equilibrium models of the real exchange rate into two main blocks: (i) estimates based on internal and external balances (fundamental equilibrium exchange rates, or FEER) and (ii) estimates based on a set of reduced general equilibrium equations (behavioural equilibrium exchange rates, or BEER). The more traditional approach of purchasing power parity, meanwhile, is based on the notion that, in the long run, a currency should be able to buy the same basket of goods and services in different places.
• 2. See William Cline (2017, 2018). «Estimates of Fundamental Equilibrium Exchange Rates». Peterson Institute for International Economics.
• 3. According to the IMF, the implicit exchange rate according to PPP theory is around 1.30 for the main euro area countries.

Our forecast scenario that the dollar could continue along a path of moderate depreciation in the medium term is based on a view of relative economic stability, with assumptions that (i) a recession in the world economy (both in the euro area and in the US) is avoided, (ii) inflation gradually returns to the 2% target rate, and (iii) central banks are able to bring the cycle of rate hikes to and end in the coming months and to begin bringing rates back down to neutral territory over the next year. Ultimately, this scenario depends on the central banks on both sides of the Atlantic being successful in their fight against inflation. Needless to say, the probability of these assumptions coming to fruition is closely tied to a set of imponderables linked to the impact of pre-existing shocks (e.g. greater persistence in the inflationary pressures or a larger effect of the monetary tightening process), as well as possible new unforeseen events (e.g. geopolitical conflicts, natural or health disasters, as well as other external factors, such as a possible change in the direction of monetary policy in Japan).