Rising U.S. dollar reflects more robust economic fundamentals in U.S. than in other major economies: Cornell University Prof. Eswar Prasad

Eswar Prasad also elaborates on how Western central banks lost control over inflation, the economic costs of inflation, the future of central bank independence, and more

A strong U.S. dollar and high inflation have been the defining global macroeconomic trends of the year. In an interview with  The Hindu, Eswar Prasad, a professor at Cornell University and the author of “The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance”, argues that the rising U.S. dollar is a reflection of more robust economic fundamentals in the U.S. than in other major economies. He also elaborates on how Western central banks lost control over inflation, the economic costs of inflation, the future of central bank independence, and more. 

The world has been hit by a series of supply disruptions that have turned out to be quite persistent. This includes COVID-related disruptions to global supply chains (including the effects of China’s zero-COVID policy), the Russian invasion of Ukraine, and a number of natural disasters. Economic theory is clear that monetary policy is generally the wrong tool to counteract price increases due to supply disruptions.

However, one element that some central bankers seem to have misread is how consumer demand has remained strong and added to inflationary pressures, particularly in economies such as the United States. The enormous amounts of central bank money creation and government spending in the years since the global financial crisis of 2008-2009, both of which were ramped up further to deal with the COVID-related recession, also created latent inflationary pressures. These pressures remained dormant until the combination of strong demand and weak supply eventually triggered the recent surge in inflation.

The risk for central bankers is that they lose control of the inflation narrative if expectations about future inflation become entrenched. Rising inflation expectations can become a self-fulfilling prophecy as workers demand higher wages and firms increase prices in tandem, making it very difficult to then rein in inflation.

High inflation is often accompanied by rising wages as workers try to protect the purchasing power of their incomes. The effects of high inflation usually fall hardest on the poor, who might not have steady incomes or formal sector employment that allows them to make wage gains to match inflation. Spending on food and energy constitutes a large share of the consumption baskets of poorer households, so high inflation in food and energy is particularly hard on them. Moreover, they would not benefit from the increase in the nominal value of financial assets simply because they tend to have few such assets to begin with. 

High inflation also tends to be more volatile; in turn, this volatility and uncertainty can dampen investment by firms, which has adverse effects on employment and output growth. High inflation also corrodes confidence in the government and the central bank, which can create a dynamic of rising inflation that can spin out of control and cause further economic disruption. 

The dollar’s strength is symptomatic of and also a contributing factor to economic and financial distress around the world. The dollar’s continued rise reflects a combination of more robust economic fundamentals and stronger inflationary pressures in the U.S. than in most other major economies, which together presage further interest rate hikes by the Fed.