The Global Dollar Cycle

Abstract

The U.S. dollar's nominal effective exchange rate closely tracks global financial conditions, which themselves show a cyclical pattern. Over that cycle, world asset prices, leverage, and capital flows move in concert with global growth, especially influencing the fortunes of emerging and developing economies (EMDEs). This paper documents that dollar appreciation shocks predict economic downturns in EMDEs and highlights policies countries could implement to dampen the effects of dollar fluctuations. Dollar appreciation shocks themselves are highly correlated not just with tighter U.S. monetary policies, but also with measures of U.S. domestic and international dollar funding stress that themselves reflect global investors' risk appetite. After the initial market panic and upward dollar spike at the start of the COVID-19 pandemic, the dollar fell as global financial conditions eased; but the higher inflation that followed has induced central banks everywhere to tighten monetary policies more recently. The dollar has strengthened considerably since mid-2021 and a contractionary phase of the global financial cycle is now under way. Owing to increases in public-and business-sector debts during the pandemic, a strong dollar, higher interest rates, and slower economic growth will be challenging for EMDEs.

External Sector Report, 2023

“…The chapter estimates cross-border spillovers with a state-dependent local projections (LP) methodology, following Obstfeld and Zhou (2023). To isolate the role of the global dollar cycle, the analysis simultaneously controls for other established factors influencing US dollar fluctuations, including monetary policy developments, broader US financial conditions, and economic activity trends in the rest of the world.…”

“…A large literature has highlighted the impact of global financial cycles on economic activity and policy trade-offs and studied the channels of transmission (see, for example, Rey 2013; Bruno and Shin 2015;and Kalemli-Özcan 2019). A more recent strand of this literature has put the US dollar at the center of global financial market booms and busts (see, for example, Druck, Magud, and Mariscal 2018; Shin 2020; Shousha 2022;Akinci and others 2022;Obstfeld and Zhou 2023;and Fukui, Nakamura, and Steinsson 2023). In particular, Obstfeld and Zhou (2023) find that the US dollar is closely related to global financial conditions even after established factors such as US monetary policy and US domestic financial conditions are controlled for, and they link the "global dollar cycle" to large negative spillovers to economic activity in emerging markets, through both financial and trade channels.…”

“…A more recent strand of this literature has put the US dollar at the center of global financial market booms and busts (see, for example, Druck, Magud, and Mariscal 2018; Shin 2020; Shousha 2022;Akinci and others 2022;Obstfeld and Zhou 2023;and Fukui, Nakamura, and Steinsson 2023). In particular, Obstfeld and Zhou (2023) find that the US dollar is closely related to global financial conditions even after established factors such as US monetary policy and US domestic financial conditions are controlled for, and they link the "global dollar cycle" to large negative spillovers to economic activity in emerging markets, through both financial and trade channels. Given the US dollar's dominant role in global finance, the global dollar cycle is a convenient barometer for studying the implications of booms and busts in global financial markets, capturing factors such as changes in investor risk appetite and preference for liquidity.…”

“…Building on Obstfeld and Zhou (2023), this chapter zooms in on the external sector implications of the global dollar cycle for a sample of emerging markets and small advanced economies. The chapter's external sector focus is motivated by the centrality of the current account for exchange rate-induced macroeconomic adjustment, capturing the propensity of countries to buffer or magnify the impact of US dollar fluctuations.…”

Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants and Disconnect

“…For the pervasive impact of a strong dollar on emerging markets, seeObstfeld and Zhou (2022).31 Such interventions are in similar spirit to the dollar swap line operations conducted by central banks in the advanced economies. To see why the cost of intervening in the NDF market would likely be small, note that ex ante, the cost of intervention is the gap between the forward rate and the expected exchange rate ©International Monetary Fund.…”