And closer to home, the US Dollar (USD) is in great peril. It’s fighting to remain afloat as the tit-for-tat trade war between the US and China escalates. The current trade conflict with China has contributed to a weakened USD. After all, this currency is not just the official money of the United States, but the ‘de facto’ currency of more than 100 other countries and territories around the world. This is exactly the state of play that has so many investors and policymakers worried today. Big swings in the dollar’s value would be quite disruptive for the overall global economy as well.
So far this week, the US Dollar Index (DXY) has fallen to 99.50. It had come back as high as nearly 100.00 before pulling back, as shown on the weekly chart below. Specifically, the immediacy of key economic developments in raising the importance of the Fed’s monetary policy decisions. This influence is critical in light of the Fed’s dual mandate to maintain both price stability and maximum sustainable employment. Inflation rates, unemployment levels, Federal Reserve interest rate hikes—each of these factors, and more, are closely intertwined. This dynamic is a key to understanding today’s USD.
The Significance of the US Dollar
The US Dollar is the United States’ official, federal currency. It is the critical underpinning of global finance, as well. It represents more than 88% of all foreign exchange turnover, making it the most actively traded currency in the world. Daily transactions conducted with the USD total over $6.6 trillion, highlighting its continued hegemony over international markets.
In the post-World War II era, the USD replaced the British Pound as the world’s leading reserve currency. This shift has allowed the dollar to be accepted and used for transactions in almost every nation in the globe. In most of these countries, it circulates alongside local currencies, giving additional stability and confidence for riskier trade and investment.
While the dollar’s superpower status as a reserve currency provides it far reaching benefits, there are inherent vulnerabilities. Yet when inflation rates fall below the Fed’s stated target of 2%, they panic. They can decide to cut interest rates to help spur economic activity, particularly if the jobless rate heads too high. Such moves typically tend to depress the dollar’s value. When interest rates are lower, the currency tends to be in lower demand.
Federal Reserve’s Role and Monetary Policy
The Federal Reserve, or the Fed, is one of the most powerful forces shaping the US economy. Most importantly, it controls inflation, and thus affects the dollar’s value, through the execution of its monetary policy. The Fed’s dual mandates require it to maintain price stability while promoting full employment. To meet those goals, it uses interest rate increases and decreases as its main tool to do so.
In times of economic crisis, the Federal Reserve frequently resorts to quantitative easing (QE). That’s usually the case when inflation is low or unemployment is high. This unconventional monetary policy means flooding the market with cash by buying up government securities or other financial assets. After all, the purpose of QE is to stimulate slack economic activity.
Size of effects
On the one hand, such a measure would strengthen fiscal policy by enhancing expected future tax revenues.
With the recent economic downturn, there has been a renewed push to address the shortcomings in the Fed’s approach. As inflation continues to fluctuate and economic indicators show mixed signals, analysts are closely monitoring how these factors influence monetary policy decisions. Whether the Fed is able to manage this delicate balance will be pivotal to the future direction of the USD.
Impact of Trade Wars on Currency Value
The economic realities brought on by the continuing trade war between the US and China have thrown the value of the US Dollar into complete disarray. As tensions rise between these two economic giants, investors are becoming more and more skeptical, causing volatile currency movement. A tense trade relationship could lead to increased uncertainty about long-term economic growth potential, pulling down demand for the dollar.
When trade disputes happen, the fear of losing export competitiveness can result in a reduction of domestic manufacturing and job growth. This same situation compounds the Fed’s challenge of achieving both full employment and stable inflation. Businesses can no longer anticipate consistent demand for their products due to new tariffs or trade barriers. As a result of that, they may overall retract on investment and hiring, increasing unemployment rates.
As a result of these dynamics, analysts are watching closely how ongoing trade negotiations will affect both the economy and the USD. Passage of a dollar resolution would provide the dollar with the stability and moral authority it desperately needs. If uncertainty persists, it could keep putting downward pressure on its value.