USD is still 'king' in Europe

Due to close financial and trade relations, the impact of the USD appreciation or the Fed raising interest rates in Europe can sometimes be greater than in the US.

Americans are not the only ones anxiously watching to see if the Federal Reserve will raise interest rates or push the country into recession; Europeans and many other countries are too. That’s because despite all the talk of deglobalization and dedollarization, the dollar is still king there. The financial and trade ties between the United States and its key partners are stronger than ever. In the case of Europe, they are even stronger.

Early last year, the European Central Bank (ECB) tried to chart a different course from the Fed. It planned to keep interest rates low despite the Fed’s rate hikes. But after the euro fell against the dollar, the ECB was forced to quickly reverse course, fearing inflationary imports from energy paid for in dollars.

Now the challenge is in reverse. The Fed has signaled it will pause its rate hikes at its June policy meeting to see whether the 5 percentage point increase since the beginning of last year has slowed the US economy significantly. That could make it harder for the ECB to raise rates while it faces high inflation. "The dollar plays a dominant role in the global economy ," said Maurice Obstfeld, former chief economist of the International Monetary Fund.

Talk of the dollar losing its reserve currency status has been growing as countries like Saudi Arabia, China and Russia increasingly use other currencies. This is in response to the US “weaponizing” the dollar, such as freezing Russia’s foreign reserves. The dollar accounted for less than 60% of global official foreign exchange reserves in the second quarter of 2022, compared with 72% two decades ago. So it is losing its dominance.

The US accounts for only about a quarter of global output and just over 10% of global trade, but nearly half of world trade is denominated in dollars. The greenback was involved in nearly 90% of global foreign exchange transactions last year, according to the Bank for International Settlements.

About half of all international debt securities and cross-border loans issued in foreign debt markets are also denominated in dollars. These links transmit higher US interest rates to other economies in a number of ways. For example, they suck capital out of economies, push up borrowing costs and cause other currencies to depreciate against the dollar.

About a third of the change in interest rates caused by the Fed tightening resulted in an equivalent increase in German interest rates, according to ECB research. As the dollar strengthens, commodities priced in the currency — such as oil — become more expensive. Higher interest rates also slow US growth, reducing demand for foreign goods.

This means that Fed rate hikes affect the European economy as much as they do the US, according to the ECB. The study also found that Fed tightening from 1991 to 2019 reduced industrial output, stock prices, business loans and inflation in the eurozone, while also putting pressure on world trade outside the US. In contrast, ECB actions had little impact on the US economy.

ECB officials closely watch the Fed's policy actions and monitor the euro-dollar exchange rate. "When the Fed leads, others follow without hesitation," said Panicos Demetriades, a former ECB official and former governor of the central bank of Cyprus.

Of course, the ECB is not just following the Fed completely, but is also taking its own actions to deal with inflation. ECB President Christine Lagarde has acknowledged that money has an impact. Any spillover effects will be taken into account, but she has said she is not relying on the Fed. "We have more room to maneuver and we will not stop," she said of dealing with inflation in early May.

However, the ECB's next moves also depend largely on the US. Expert Maurice Obstfeld said the ECB's policy interest rate is about 2 percentage points lower than the Fed's and they do not have time to catch up.

Going forward, whether the ECB tightens further will depend on whether the Fed pushes the US into recession. For Europe, exports — especially to the US — are a rare pillar of strength when domestic purchasing power is waning. Trade in goods between the EU and the US rose to $86 billion in March, up about 8% from a year earlier, according to the US Census Bureau.

If the US falls into recession in the coming months, its imports could fall, depriving Europe of a pillar of growth. In return, that would weaken the dollar, giving Europe cheaper energy and fewer inflationary imports. That means a US recession would make life harder for Europeans but easier for the ECB to deal with.

"Europe as a whole is in a pretty precarious situation, which will make the ECB cautious," Obstfeld assessed.

Phien An ( according to WSJ )

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