The US Dollar Index being at a high of 114 and up 20 per cent this year, it has been triggering mayhem across global stock, bond and currency markets. But what does the US dollar have to do with the Rupee or the Nifty50? The Dollar Milkshake Theory offers insights into this.
Persistent US inflation and relentless rate hikes by the US Fed are now causing a hangover across global economies that willingly joined the party when money was offered ‘free’. Nobel Laureate late Milton Friedman, once famously said that inflation was like alcoholism. When it comes to money printing, the good effects come first and the bad effects come later. In his opinion, this was why there is always a strong temptation to overdo it.
But when it comes to the cure, which is restricting money supply to control inflation, Friedman said, the bad effects come first and the good effects come later. The good effects are usually price stability and growth. Looking at the surging global inflation, it is now evident that central banks and governments in developed countries overdid their monetary and fiscal stimulus during Covid. Thus, the rate hikes by the Fed, inevitable as they are to rein in inflation, are upending a global economy. The bad effects are playing out first now!
As the Fed ‘does what it takes’ to tame inflation and hikes rates, the US dollar has been on a strengthening spree. The dollar’s rise could see the world economy facing more pain from the Fed’s moves than the US itself.
This is where the ‘Dollar Milkshake Theory’, propounded by Brent Johnson of Santiago Capital comes in. The theory talks of the pain that an extended period of strong dollar can inflict on the global economy. The theory says that, as the US Fed tightens monetary policy faster than other major central banks, the milkshake of liquidity created globally by central banks’ loose policies, will flow into the US shoring up the dollar. As investors see risks rising, they prefer the safe haven of the US dollar and their home-country bias adds to this flight.
This could hit many emerging economies and even a few developed economies. A lot of international debt is denominated in US dollars (60 per cent per a Fed report), at time when global growth is slowing down sharply. Events like the default by Sri Lanka, also highlight the vulnerabilities of emerging markets if the dollar continues to strengthen. Wild cross-currency swings between the Euro, British Pound and the Dollar in recent weeks offer glimpses of what can play out, if this theory turns out to be correct.
In this context, India appears to be in a strong position, because the government has negligible overseas borrowings and is sitting on solid reserves, with relatively lower inflation. This explains the Rupee outperforming major currencies other than the dollar this year. But some caution and planning is warranted to be prepared for a possible global currency crisis.
The dollar index is now at a 20-year high following the series of Fed rate hikes. Constricting as it is for US economic growth and exports, it comes with silver lining of making global commodities prices (priced in dollars) and imports into the US cheaper.
This can be a source of succour to the Fed’s single-point agenda of bringing inflation back to 2 per cent. However, the rest of the world has to deal with the consequences of this. To paraphrase former US Treasury Secretary John Connolly, the dollar now is our problem.