The U.S. dollar has been on a tear this summer. The Japanese yen and the euro have fallen to their lowest levels against the greenback in two decades; the euro, long worth more than one dollar, is now hovering close to parity. The U.S. Federal Reserve’s broad trade-weighted dollar index has almost re-attained the peak it reached in March 2020 amid the panic triggered by the start of the Covid-19 pandemic. In fact, if one adjusts for inflation in the United States and its trading partners, it is already higher.

This is happening despite the U.S. recording its highest annual inflation rate in four decades and its worst trade balance since the global financial crisis. What is going on, and is the dollar set to plummet?

While acknowledging that exchange rates are extremely difficult to explain, much less predict, four major factors seem to be influencing the movements of the world’s major currencies. Most importantly, the Fed has begun hiking interest rates, and with the U.S. economy seemingly nowhere near a true recession, there is still room for it to tighten policy further.

Despite equally high inflation in Europe, the European Central Bank is being more cautious. This is partly because the economic outlook for the eurozone is more fragile. The ECB is worried about Italy’s high debt levels, but also believes that current rates of energy-price inflation will not continue. Japan, like China, has so far not experienced significant inflation. The Bank of Japan is unlikely to tighten policy anytime soon, and the People’s Bank of China cut rates in August.

Geopolitics is also a factor behind the dollar’s strength. The war in Ukraine presents a much more immediate risk to Europe than to the U.S., while China’s ominous saber-rattling toward Taiwan is a huge risk for everyone, but most of all to neighboring Japan. Recession or not, both Europe and Japan will have to restructure their defense capabilities significantly, with a concomitant rise in long-term military expenditures.

Then there is the ongoing economic slowdown in China, which affects Europe and Japan far more than America. The root causes of China’s decelerating growth—including zero-Covid lockdowns, the legacy of overbuilding, a crackdown on the tech sector, and over-centralization of economic power—are issues I have been commenting on for some time, and I do not see a sharp, sustained turnaround.

Finally, with energy prices still very high, the fact that the U.S. is self-sufficient in energy while Europe and Japan are huge importers also benefits the dollar.

Some would add that the U.S. is a safer haven than Europe and Japan. That may be true, despite America being mired in a cold civil war that can have no end as long as former President Donald Trump is in the mix. Eurozone integration, which promises to advance whenever there is a crisis, will be sorely tested if global real interest rates ever start rising. Inflation in Germany is on track to hit a 70-year high, but more aggressive ECB interest-rate hikes could cause spreads on Italian government debt to explode.

The dollar’s current strength has profound implications for the global economy. A large share of world trade, perhaps half, is denominated in dollars—and for many countries, that applies to both imports and exports. As such, a rise in the dollar causes much of the world to cut back on imports, so much so that researchers have found a statistically significant negative impact on global trade.

A strong greenback risks having a particularly brutal effect on emerging markets and developing economies, because private firms and banks in these countries that borrow from foreign investors can do so pretty much only in dollars. And higher U.S. interest rates tend to push up weaker borrowers’ interest rates disproportionately. In fact, the broad dollar index would have risen even more had many emerging-market central banks not proactively raised interest rates to stem downward pressure on national currencies. But such tightening of course weighs on their domestic economies.

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