Recent United States inflation data has confirmed the market's worst fears. In August, US inflation was at 8.3 percent, lower than July’s 8.5 percent but still higher than market expectation of 8.1 percent. It was caused by stubbornly high prices for essential goods and services-shelter, healthcare and transport costs – contributed by a tight labor market.

On the other side, the prices of petrol, gas and airfares dropped, thanks to efforts by the government and private sector to increase and redirect energy supply. This trend is likely to continue as the next US jobless claims on Thursday is expected to still show a strong US labor market.

As a response, major global stock indices plunged into deep red territory with the Dow Jones losing as much as 1,300 points. The Federal Reserve, America’s central bank, is likely to hike its benchmark funds rate significantly more “jumbo” – perhaps even 100 basis points (a full 1 percent) – in the next Fed Governing Board meeting on Wednesday.

The possibility of a soft landing – Fed tightening without inflation – now seems remote and a hard landing, while Fed tightening caused a US recession seems more possible. For the Fed, running the economy into the depths of a recession now is more favorable rather than allowing inflationary expectations to run wild and then even more extreme interest rate hikes like those in the stagflation periods of the 1970s and 80s.

A more hawkish Fed can push the dollar’s strength on steroids. Currently the greenback has already strengthened significantly against its developed markets (yen 30.4 percent, pound sterling 19.9 percent and euro 18.3 percent) and emerging markets peers (ringgit 8.3 percent and rupiah 4.8 percent).

Interestingly, developed market currencies are hit harder than emerging market economies as the former tend to be importers of now more expensive raw materials and commodities. Meanwhile emerging markets have anticipated the Fed’s hawkish turn by raising interest rates sooner and some emerging markets such as Indonesia are also major producers of commodities, benefitting from the global surge in prices.  

The dollar’s extreme strength and a brutally hawkish Fed will be a major problem for the global economy. As countries try to defend or slow the depreciation of their currencies, it will eat away their foreign reserves. In Southeast Asia, levels of foreign exchange (FX) reserves have fallen to the lowest point since the global financial crisis of 2008. Even China, the holder of the world’s largest pile of FX reserves, has spent US$49.2 billion defending the Chinese renminbi in August.

Lower FX reserves mean countries will be more vulnerable to currency and liquidity crises. A stronger dollar also slows down economic growth as almost all commodities are priced in the greenback or use the greenback in its settlement.

Meanwhile the potential of a liquidity and debt crisis looms large as global debt levels remain high after the COVID-19 pandemic. As the Fed tightens monetary policy and bond yields continue to rise, countries will find it increasingly difficult to settle debts and payments in US dollars. Already this is causing debt distress in multiple countries in Asia and Africa.

While the Fed has established swap lines, it is only to its “allies” (Japan, Europe and some countries in Latin America). A liquidity crisis in poor and non-US allies can quickly domino and push the global economy into a tailspin.

Moving forward, there is little any country can do to stop the dollar’s rise as it reflects the relative strength of the US economy and its dominant position as the global hegemon. A multilateral Plaza Accord style deal is also unlikely. For the Biden administration, a stronger US dollar will taper domestic inflation, which will be important for the midterm elections.

Sharpening geopolitical competition with China and Russia will render any major global cooperation unfeasible. In addition, the Chinese renminbi has only depreciated by around 10 percent, much less than the yen or the euro.

Ironically prolonged periods of extreme dollar strength may hasten the end of the dollar’s dominance. More expensive commodities and difficulties in financing may incentivize other countries to shift to other cheaper and less weaponized currencies.  China can make use of the moment and offer to bail out debt-distressed nations in exchange for usage of Chinese renminbi in trade and investment, paving the way for a new phase of renminbi internationalization.

Meanwhile Indonesia stands as a beneficiary of the current global environment of high commodity prices that fuels domestic consumption and investment activities. The rupiah is one of the best performing emerging market currencies of the year, supported by high coal prices and some inflows in the equity markets.

However, this is not without its costs as Bank Indonesia’s FX reserves have already declined $9.1 billion as of August of this year and there is no guarantee high coal prices will stay. Major downside risks include consistently high energy and food prices which may force BI to hike rates more aggressively, jeopardizing the already slowing economic recovery.

A major debt or liquidity crisis will still pose a threat to the country’s financing needs, especially in capital intensive infrastructure projects.

For now, Indonesia should make use of its advantageous position: conserving US dollar liquidity, saving the proceeds of the commodity boom for future needs, diversifying its markets and integrating itself into a diverging global supply chain.  

BI’s recent moves to promote local currency settlement and the government’s downstream policies are good steps but are not enough. The country needs to fundamentally transform its ease of business, attract foreign capital into productive sectors and boost labor productivity.

It is not a time to be complacent. It is time to seize the moment and change.

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The writer is a public policy analyst.