The return of the US dollar

• Published date: 12 November 2014
• Publication title: Gulf Times

The US dollar is on the move. In the last four months alone, it has soared by more than 7% compared with a basket of more than a dozen global currencies, and by even more against the euro and the Japanese yen.

This dollar rally, the result of genuine economic progress and divergent policy developments, could contribute to the "rebalancing" that has long eluded the world economy. But that outcome is far from guaranteed, especially given the related risks of financial instability.

Two major factors are currently working in the dollar's favour, particularly compared to the euro and the yen. First, the US is consistently outperforming Europe and Japan in terms of economic growth and dynamism and will likely continue to do so owing not only to its economic flexibility and entrepreneurial energy, but also to its more decisive policy action since the start of the global financial crisis.

Second, after a period of alignment, the monetary policies of these three large and systemically important economies are diverging, taking the world economy from a multispeed trajectory to a multitrack one.

Indeed, whereas the US Federal Reserve terminated its largescale securities purchases, known as "quantitative easing" (QE), last month, the Bank of Japan and the European Central Bank recently announced the expansion of their monetarystimulus programmes.

In fact, ECB president Mario Draghi signalled a willingness to expand his institution's balance sheet by a massive A¢‚¬sA‚¬1tn ($1.25tn).

With higher US market interest rates attracting additional capital inflows and pushing the dollar even higher, the currency's revaluation would appear to be just what the doctor ordered when it comes to catalysing a longawaited global rebalancing one that promotes stronger growth and mitigates deflation risk in Europe and Japan.

Specifically, an appreciating dollar improves the price competitiveness of European and Japanese companies in the US and other markets, while moderating some of the structural deflationary pressure in the lagging economies by causing import prices to rise.

Yet the benefits of the dollar's rally are far from guaranteed, for both economic and financial reasons. While the US economy is more resilient and agile than its developed counterparts, it is not yet robust enough to be able to adjust smoothly to a significant shift in external demand to other countries.

There is also the risk that, given the role of the ECB and the Bank of Japan in shaping...