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Stirring ingredients of 1985’s dollar-capping Plaza Accord

There’s a familiar air of 1985 about – and not just in Cold War politics or the gull-wing DeLoreans in “Back to the Future”.

With inflation rates as high as those of the early 1980s, U.S. interest rates rising faster than those of other major economies and the dollar rocketing worldwide, it’s not surprising to see investors making references to 1985’s “Plaza Accord”.

Named after the New York hotel where finance chiefs of the then G5 world powers agreed to weaken a super-charged dollar through market intervention, Plaza became an iconic moment in economic cooperation of the post-1973 floating currency era.

Borne of divergent monetary policies and Federal Reserve chief Paul Volcker’s resolve to finally stamp out double-digit inflation from the 1970s oil shocks, the extreme dollar strength that ensued proved destabilising for U.S. exporters and inflationary for U.S. trading partners. The G5 resolved to correct the overshoot.

It was so successful in pushing the dollar lower against the German mark, Japanese yen, French franc and British pound, that the Western powers were forced to reverse tack in Paris two years later and shore up the greenback.

With Fed tightening back in overdrive after the pandemic as long-dormant inflation rages at its highest since 1982, the dollar’s index hit 20-year highs this month – gaining some 16% in a year and more than 30% over the past eight years.

There’s good reason for anxiety. So crucial is the dollar still to world financing, commodity pricing and trade invoicing that extreme dollar strength tends to feed off itself – with a rising dollar exaggerating global financial stress as well as acting as both a haven from and a hedge against the disruption.

What’s more, the dollar is approaching what Cazenove Capital chief investment officer Caspar Rock calls “emotive levels” – even if the resulting financial stress is probably not yet extreme enough for international action.

Euro/dollar is less than 5% from parity last seen 20 years ago. Sterling is just 7% from pandemic lows against the dollar, below which 1985 levels hove into view. And dollar/yen is above 130 for the first time in 20 years, albeit still half the rate it was in the mid-80s.

While the Fed might welcome a stronger dollar in its battle against 8%-plus inflation, European countries more dependent on energy imports and closer to Ukraine-related supply shocks can only see a stronger dollar exaggerating their cost-of-living squeeze. Japan will balk at the oil import bills too.

If currency markets overshoot, as they so often do, could there be a case building for an official shot across the bows against dollar strength? A Plaza-lite, perhaps?

Hedge fund manager Stephen Jen at Eurizon SLJ thinks there’s good reason to look at the early 1980s for a “strong resemblance” to the current U.S. economic policy mix – even though he doubts we’ll see a repeat of the excesses of that period.

For Jen, the combination of tight central bank money and loose government fiscal policy provided the perfect “mix” for currency appreciation both in the 1980s and again now.

Volcker’s anti-inflation push 40 years ago saw Fed policy rates hit as high as 19% in 1981 and return again into double digits in 1984 – just as tax cuts from then-President Ronald Reagan were aimed at stimulating the economy and offsetting the monetary squeeze.

What’s more, international monetary policies were poles apart. As Fed rates soared during the first five years of the 1980s, Bank of Japan and Bundesbank policy rates almost halved from 9% to 5% and 9.5% to 5.5% respectively.

The dollar rise went too far. The Fed’s broad trade-weighted dollar index more than doubled between 1980 and 1985 and the risk of financial instability around the world led eventually to Plaza.

There are many similarities to today – though the raw numbers do pale by comparison.

The Fed’s rebased broad dollar index has risen about 30% over the past eight years rather than doubling. U.S. fiscal policy is loose, though tightening from pandemic extremes. And policy rate divergence is far more modest.
The Fed has started to lift interest rates rapidly from zero, although futures markets assume it will top out just over 3% next year. The European Central Bank is expected to raise rates at a slower pace into just positive territory over the same horizon, though not yet going in the opposite direction. The BOJ is keeping its loose stance for now.

“We do not believe any major central bank is close to being in a position to repeat a ‘Volcker’, because of the very large balance sheets and the associated distortions – including high leverage – such unconventional monetary policies have imparted in the financial system,” Jen and colleague Joana Freire wrote. “This, in turn, should mean that the dollar strength is likely to be capped.”

Of course, the world economy and financial markets are very different beasts to those of 40 years ago. Monetary stances are more blurred by quantitative easing and central bank balance sheet policies, outright intervention on exchange markets may be less necessary or effective than stress-busting dollar swap lines established in intervening years and larger trading blocks are perhaps less currency sensitive.

Most obviously, China’s emergence as the world’s second-biggest economy means dollar strength against the yuan will also be a factor – and Beijing may need to be party to any agreement.

Yet a more polar world has re-formed since the pandemic and Russia’s invasion of Ukraine this year. G7 seems to have regained primacy as the West’s economic forum once more and the 1980s doesn’t seem such a distant memory all of a sudden. The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own
Source: Reuters (by Mike Dolan, Editing by Lisa Shumaker)

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