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The dollar's dominance is not part of a currency war and its strengthening is critical to lowering global inflation, Bank of America says

Dollar vs. Yuan
Dollar vs. Yuan

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  • The dollar's massive gains against other currencies this year isn't part of a "currency war," Bank of America said.

  • "The US is the epicenter of the global inflation problem," the bank said.

  • Dollar dominance does have consequences though, and it's already lowered the global growth outlook.

The dollar has risen sharply in 2022, but its strength shouldn't be looked at in the context of global currency wars, and the rise of the greenback is an important part of the global inflation fight, Bank of America analysts said this week. 

The US Dollar Index, which pegs the dollar against a basket of foreign currencies, surged 11% from the beginning of the year, as the Federal Reserve in March began hiking rates for the first time since 2018.

The rate hikes are an attempt by the central bank to tame skyrocketing inflation, but the impact on other countries ability to pay for US goods means that the world is in the midst of a "reverse currency war", the bank said. The situation is the opposite of what many countries have accused each other of in manipulating their currencies to be cheaper in order to draw money to their economies. The US dollar and the Japanese yen in particular have been targets for these criticisms since the early 2010s, the BofA analysts note. 

"We have always believed that 'currency war' greatly oversimplifies not only the intent of monetary policy, but also the mechanism by which one country's monetary policy impacts its trading partners," Bank of America global economist Ethan Harris said in a note on Friday.

Global central banks' inflation struggles this year has meant that the world may be involved in a "joint exercise" in controlling money supply through rate hikes. It also means that central banks are now actually competing to have the strongest currency, shifting inflation pressures around the world. 

But Bank of America believes the dollar's rise is necessary to rein in inflation. As the center of the global inflation problem, the dollar's strength will therefore also be key to tackling the problem on a global scale, the analysts said. 

"In many ways, the US is the epicenter of the global inflation problem ... Getting the US consumer and labor markets back into equilibrium is central to lowering global inflation."

They added that the Federal Reserve has been more aggressive in its rate hikes than other central banks because the US was "late" in addressing runaway inflation, which economists began flagging as a problem in 2021.

Harris admitted though that dollar dominance still had consequences on the foreign exchange market. In particular, it can hurt small and open economies, as those are more likely to have their currency depreciate relative to the dollar, making it harder for them to maintain their purchasing power in the global economy. And it can especially hurt commodity importers, as commodities are often priced in US Dollars.

That has already led to some harm, Harris noted, and the appreciation of the dollar has led to lower global growth estimates.

But results of the US's inflation fight could soon show results. Though the International Monetary Fund issued an ominous outlook for the global economy, inflation expectations in the US bond market are beginning to ease and stocks rebounded during the month of July as investors anticipate inflation has peaked and the Fed may not have to hike rates as aggressively to rein in prices. 

Read the original article on Business Insider