So far the US dollar has been remarkably firm during the pandemic, mainly because major central banks’ policy interest rates are effectively frozen at or near zero. But although the current stability could last awhile, it will not may forever.
With alternative assets such as gold and Bitcoin flourishing in the pandemic, some top economists are predicting a sharp fall in the US dollar. This could yet happen. But so far, despite inconsistent US management of the pandemic, massive deficit spending for economic catastrophe relief, and monetary easing that Federal Reserve Chair says has “crossed a lot of red lines,” core dollar exchange rates have been weirdly calm. Even the election tensions did not have much impact.
To be sure, the euro has appreciated by roughly 6% against the dollar so far in 2020, but that is a small appreciation compared to the extreme changes that took place after the 2008 financial crisis, when the dollar fluctuated between $1.58 and $1.07 to the euro. Similarly, the yen-dollar exchange rate has hardly moved during the pandemic, but varied between ¥90 and ¥123 to the dollar in the Great Recession. And a broad dollar exchange-rate index against all US trading partners is currently sitting at roughly its mid-February 2020 level.
Such stability is surprising, given that exchange-rate volatility normally rises significantly during US recessions.
Economists have known for decades that explaining currency movements is extremely difficult. Nevertheless, the overwhelming presumption is that in an environment of greater global macroeconomic uncertainty than most of us have seen in our lifetimes, exchange rates should be shifting wildly. But even as a second wave of COVID-19 has stunned Europe, the euro has fallen only by a few percent – a drop in the bucket in terms of asset-price volatility.
Fiscal stimulus talks in the United States are on one day, off the next. And although America’s election uncertainty is moving toward resolution, more huge policy battles lie ahead. So far, though, any exchange-rate response has been relatively small.
Nobody knows for sure what might be keeping currency movements in check. Possible explanations include common shocks, generous Fed provision of dollar swap lines, and massive government fiscal responses around the world. But the most plausible reason is the paralysis of conventional monetary policy. All major central banks’ policy interest rates are at or near the effective lower bound (around zero), and leading forecasters believe they will remain there for many years, even in an optimistic growth scenario.
If not for the near-zero lower bound, most central banks would now be setting interest rates far below zero, say, at minus 3-4%. This suggests that even as the economy improves, it could be a long time before policymakers are willing to “lift off” from zero and raise rates into positive territory.
Interest rates are hardly the only likely driver of exchange rates; other factors, such as trade imbalances and risk, also are important. And, of course, central banks are engaged in various quasi-fiscal activities such as quantitative easing. But with interest rates basically in a freeze, perhaps the single biggest source of uncertainty is gone. In fact, core exchange-rate volatility was declining long before the pandemic, especially as one central bank after another skirted the zero bound. COVID-19 has since entrenched these ultra-low interest rates.
But the current stasis will not last forever. Controlling for relative inflation rates, the real value of a broad dollar index has been trending up for almost a decade, and at some point will probably partly revert to the mean (as happened in the early 2000s). The second wave of the virus is currently hitting Europe harder than the US, but this pattern may soon reverse as winter sets in, particularly if America’s post-election interregnum paralyzes both health and macroeconomic policy. And although the US still has enormous capacity to provide much-needed disaster relief to hard-hit workers and small businesses, the growing share of US public and corporate debt in global markets suggests longer-term fragilities.
