Global currency wars have begun because, well, inflation

Illustration: Khylin Woodrow for Bloomberg Businessweek/Bloomberg

The European Central Bank's Isabel Schnabel started it. In February she flashed a chart showing how much the euro had weakened against the US dollar. Two months later, the Bank of Canada's Tiff Macklem bemoaned the decline of the Canadian dollar. Swiss National Bank President Thomas Jordan suggested he'd like to see a stronger franc.

The US dollar had been soaring—now up 7% for the year—as the Federal Reserve prepared to aggressively combat inflation. And so one by one, central bankers elsewhere, just as desperate to tame the relentless march of inflation in their own backyards, began sending not-so-subtle signals that they would for once welcome a stronger currency—which helps reduce the cost of imports by boosting buying power abroad. It's a form of intervention so rare that their jawboning alone moved markets. On June 16, two of them upped the ante: Switzerland surprised traders with the first rate increase since 2007, sending the franc soaring to its highest level in seven years. Hours later, the Bank of England announced its own rate increase and signaled bigger hikes to come.

The value of currencies has emerged as an ever-larger part of the inflation equation. Goldman Sachs Group Inc. economist Michael Cahill says he can't recall a time when the central banks of developed nations have ever targeted stronger currencies so aggressively. The foreign exchange world is calling it the "reverse currency war"—because, for more than a decade, countries sought the opposite. A weaker currency meant domestic companies could sell goods abroad at more competitive prices, aiding economic growth. But with the cost of everything from fuel to food to appliances soaring, strengthening buying power has suddenly become more important.

It's a dangerous game. If left unchecked, this international competition threatens to trigger wild swings in the value of the most dominant currencies, handicap manufacturers that rely on exports, upend the finances of multinational companies, and shift the burdens of inflation around the world.

Foreign exchange wars are notoriously a zero-sum game. There will be winners and losers. Every country "wants the same thing," says Alan Ruskin, chief international strategist at Deutsche Bank AG, but "you can't have that in the currency world."

One of the most notable large-scale government interventions in currency markets came in 1985. The value of the US dollar had shot up during President Ronald Reagan's first term on the back of rising long-term interest rates, reaching its highest-ever level against the British pound.

The administration initially saw this as a tribute to the strength of the US economy, but the drawbacks soon became clear. Reagan came under pressure from US manufacturers who were finding it increasingly difficult to market their goods abroad. Lee Morgan, former chief executive officer at machinery giant Caterpillar Inc., estimated that hundreds of US companies were losing billions of dollars in international orders annually to Japanese competitors because of the stronger dollar.

In September 1985, US central bankers met with their French, German, Japanese, and British counterparts at the Plaza Hotel in New York City. In what became known as the Plaza Accord, they came up with a plan that would drive the US currency down 40% in the ensuing two years until finance ministers signed the Louvre Accord in Paris that ended the effort.

Since then, governments have rarely intervened so explicitly to influence the value of currencies. Subtler attempts are more commonplace. In 2010, Brazilian Finance Minister Guido Mantega gave "currency wars" their name when he accused countries including Switzerland and Japan of deliberately weakening their currencies to increase their competitiveness abroad. The tensions deepened the rift between emerging-market economies and their more developed counterparts.

China has inflamed critics for years by refusing to allow the yuan to strengthen as cheap exports fueled an economic boom. Donald Trump targeted the country's exchange rate on the campaign trail. As the US and China traded blows with tit-for-tat tariffs during his presidency, China allowed the yuan to weaken below the symbolic level of 7 to the dollar—a line it hadn't crossed in more than a decade—raising alarms that the currency might be "weaponized" and prompting the US Department of the Treasury to brand China a currency manipulator.

Perhaps no country today is better known for its efforts to keep a lid on the value of its currency than Japan, where the yen's decline has padded the pockets of companies such as Toyota Motor Corp. and Nintendo Co. Bank of Japan Governor Haruhiko Kuroda has continued to signal a dovish stance—while conceding that the yen's plunge is not good for the economy. The currency has fallen more than 18% this year, and foreign exchange traders are increasingly betting on the day when central bankers there will have no choice but to reverse their stance.

In today's currency war, the strong US dollar arguably has the most to lose. Its gains in 2022 have proven a blessing for a Federal Reserve that's trying to fight the fastest price gains in four decades. Treasury Secretary Janet Yellen has stressed the Biden administration's commitment to a "market-determined" exchange rate, but that hasn't stopped politicians from celebrating the dollar's gain. "The Fed has to do its job—it's got to stay this course" in fighting inflation, Pennsylvania Senator Pat Toomey, a Republican, said on Bloomberg Television in May. But the strength of the dollar is "doing a lot to help," he said.

The US may not enjoy this advantage for long. The Swiss and British rate increases have already weighed on the dollar, which earlier in June notched its biggest two-day drop since March 2020.

Some industries will welcome the weakening. Salesforce Inc. says it expects the dollar's gain to cost it $600 million in revenue this fiscal year. "The dollar might have even had a stronger quarter than we did," CEO Marc Benioff said during an earnings call in May.

Developing countries, especially exporters such as Argentina and Turkey, are among the most vulnerable, says Harvard economics professor Jeffrey Frankel. A lot of emerging economies have more debt denominated in dollars than they do in their own currencies, he says: "That's the worst of all worlds—to have your currency depreciate against the dollar when you have dollar debt."

Exactly how much a stronger currency will even tamp down inflation remains unclear. The so-called pass-through rate—the degree to which a foreign exchange rate affects consumer price index—has proven minimal, says Citigroup Inc. global chief economist Nathan Sheets, who previously worked for the Treasury Department and Federal Reserve. But in an era of rampant inflation, it may do more good. A 10% gain in the dollar would've previously only damped inflation by about a half percentage point, Sheets says. Today, he says, it could be "a full percentage point."

Experts warn that any government intervention carries a high risk of failure. "Targeting exchange rates can be a very fickle and unfruitful exercise," says Mark Sobel, a former top Treasury Department official who's now US chairman for the Official Monetary and Financial Institutions Forum, a think tank. "Predicting how exchange markets may react to a given policy choice can often be a fool's errand," he says.

The European Central Bank's Isabel Schnabel started it. In February she flashed a chart showing how much the euro had weakened against the US dollar. Two months later, the Bank of Canada's Tiff Macklem bemoaned the decline of the Canadian dollar. Swiss National Bank President Thomas Jordan suggested he'd like to see a stronger franc.

The US dollar had been soaring—now up 7% for the year—as the Federal Reserve prepared to aggressively combat inflation. And so one by one, central bankers elsewhere, just as desperate to tame the relentless march of inflation in their own backyards, began sending not-so-subtle signals that they would for once welcome a stronger currency—which helps reduce the cost of imports by boosting buying power abroad. It's a form of intervention so rare that their jawboning alone moved markets. On June 16, two of them upped the ante: Switzerland surprised traders with the first rate increase since 2007, sending the franc soaring to its highest level in seven years. Hours later, the Bank of England announced its own rate increase and signaled bigger hikes to come.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.