US Dollar Exchange Rate Shifts: Drivers, Impacts and Outlook for 2023

The US dollar reached a 2-decade high against other major currencies in September 2022, following months of rapid appreciation. As of 8 February 2023, the greenback declined again markedly but still remains about 8% higher compared to a year earlier, based on the US Dollar Index. Being the currency of the largest economy in the world, fluctuations in the US dollar exchange rate have important implications for the global economy, businesses and consumers, given its impacts on investment, debt servicing and inflation.

The US dollar is widely used outside the US in international trade and finance and also serves as the dominant reserve currency for central banks around the world. This global status of the dollar is primarily driven by the strength of the US economy and the outsized influence of its financial markets, with changes in its value therefore having implications for the global economy. This global influence became particularly apparent in 2022 after a rare combination of distinct factors triggered a rapid surge of the US dollar.

Simultaneous events inside and outside the US spark dollar surge in 2022

Central to the rise of the US dollar in 2022 was a growing interest rate differential between the federal funds rate, set by the US Federal Reserve (the Fed) and other major central banks globally. In the fight against soaring inflation, the Fed started to increase its interest rate earlier, leading to consistently tighter monetary policy. In turn, this interest rate differential increased yields on US debt which attracted investment and thereby strengthened the dollar.

A major contribution to the rise of the US dollar in 2022 was a growing interest rate differential between the Fed and other major central banks globally

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Moreover, the relative strength of the US economy globally attracted investment that contributed to the dollar surge. That is because economic spillover effects from the war in Ukraine significantly worsened Europe’s economic outlook, with substantial increases in energy prices plunging the region into a trade deficit, thereby reducing the value of the euro and sterling. At the same time, China’s economy struggled with the fallout from its restrictive zero-COVID policy.

As a trusted safe haven investment for global investors in times of elevated uncertainty and risk, the US dollar also benefited from rising concerns of a global recession and financial market volatility. This was primarily driven by a deteriorating economic outlook amid surging inflation and rising geopolitical tensions following Russia’s invasion of Ukraine.

The global economy, businesses and consumers suffer from exceptional dollar strength

The dollar’s global reach and widespread influence imply that changes in its value can have significant consequences for the global economy. A surging dollar can prompt central banks globally to increase interest rates to strengthen their currencies, which, in turn, weighs on growth and financial stability. Moreover, with most commodities priced in US dollars, countries with a high reliance on imports of energy and agricultural products face additional inflationary pressures due to the dollar surge.

Emerging and developing countries are particularly vulnerable to a strong US dollar, as higher import prices and rising costs for payments to service dollar-denominated debt lead to quickly depleting US dollar reserves. At worst, this can contribute to a debt default and outflow of foreign investment, as seen in the case of Sri Lanka in May 2022.

With an appreciating dollar, businesses outside of the US with dollar-denominated debt need more local currency to convert into US dollars when making loan payments, resulting in higher borrowing costs and lower growth potential. Plus, international companies see a reduced relative value of sales made in foreign currencies when they are converted back into dollars for financial reports.

For consumers outside the US, the dollar surge exacerbated the widespread cost-of-living crisis as imports for essential goods became expensive

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For consumers outside the US, the dollar surge exacerbated the widespread cost-of-living crisis as imports for essential goods became expensive. This came in addition to already high inflation in most countries resulting from the food and energy supply shock tied to Russia’s invasion of Ukraine.

Dollar strength wanes following its peak – though volatility will remain elevated in 2023

In Q4 2022, the driving trends behind the dollar surge started to reverse, thereby setting in motion a gradual decline compared to other major currencies. Most importantly, after months of slowing inflation in the US, the Fed significantly decelerated its pace of interest rate increases, fuelling expectations that borrowing costs will not rise significantly higher in 2023.

At the same time, the central banks of the Eurozone and the UK have remained firm on rapid hikes which has created a reversed differential in monetary policy that has strengthened their currencies. Furthermore, unexpectedly, the economic outlooks in Europe and China have improved substantially due to falling energy prices and the abrupt exit from zero-COVID, thereby reducing the relative strength of the US economy.

The US dollar has eased from its peak level, but exchange rate volatility will remain elevated in 2023 on the back of global macroeconomic uncertainty

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However, although the dollar is likely to decline further in 2023, it is expected that exchange rate volatility will remain elevated. This is especially due to high macroeconomic uncertainty with ongoing global recession risks, as well as persistent US inflation due to significant shortages in its labour market which could result in higher interest rates for longer. Both developments would renew investor demand for US assets, thus boosting dollar strength. As a consequence, businesses and consumers outside the US would face a resurgence of exchange rate-related financial pressures, ultimately weighing on global growth.

For further insights on the drivers of the global economy, read our latest briefing: Global Economic Forecasts: Q1 2023.