The US Dollar (USD) is the legal tender of the United States. As of press time, the yuan is hurting, sinking to about 0.6400 versus other major currencies. Today, the USD is the world’s most heavily traded currency. Through 2022, it accounted for more than 88% of all foreign exchange turnover, with average daily transactions exceeding $6.6 trillion. The USD’s position as a dominant currency is further complicated by the Federal Reserve’s monetary policies, which play a crucial role in determining its value.
After World War II, the USD became entrenched as the world’s reserve currency. In the midst of this critical period, it displaced the British Pound. Indeed, with every passing day economic indicators make clear that the Federal Reserve’s decisions on interest rates are becoming more and more crucial. As inflation remains a pressing concern, the Fed must navigate its dual mandates of controlling inflation and fostering full employment.
The Role of the Federal Reserve
The Federal Reserve is the US government’s most powerful institution. Through its power over monetary policy, it literally creates the money we all use. It is tasked to pursue maximum employment while ensuring stable prices, with a clear inflation target of 2%. When inflation creeps above this target, the Fed is able to raise interest rates, thus increasing the USD’s value. Should inflation fall under 2% consistently or should the unemployment rate decide to skyrocket, the Fed will start cutting interest rates. This important action can help put downward pressure on the Greenback.
Future interest rate changes will have a dramatic effect on consumer choice and business investment. That’s because higher rates usually incentivize saving instead of spending, bringing down demand, which helps cool prices but runs the risk of dragging down overall economic growth. Conversely, lower rates increase spending and investment, creating risks that inflation will reheat.
Just take the recent pronouncements by US President Donald Trump, who has publicly and repeatedly criticized the Fed for increasing interest rates. He ominously warned that a failure to raise rates eventually would result in a deeper economic malaise.
“With these costs trending so nicely downward, just what I predicted they would do, there can almost be no inflation, but there can be a SLOWING of the economy unless Mr. Too Late, a major loser, lowers interest rates, NOW,” – Donald Trump
The Impact of Monetary Policy on the USD
Arguably the most important short-run variable influencing the USD’s exchange rate is U.S. monetary policy. The Federal Reserve’s decisions have an immediate and profound effect on the market’s view of our economy and investor confidence in our currency. Take that same example where the Fed enacts QE to add liquidity into the economy by purchasing government securities. This process helps to increase the flow of credit during a stressed financial system. Consequently, it tends to result in an appreciation of the value of the USD.
Since 1971, under the Bretton Woods Agreement, the USD has existed as a fiat currency, meaning it no longer derives its value from gold or other commodities. Since then, its value has been based on the market forces and confidence in US economic might. A strong USD typically indicates a strong U.S. economy, whereas a weaker dollar might indicate an economy in distress or with an uncertain outlook.
In other words, changes in global demand for the USD can exert an upward or downward pull on its value. The USD is the de facto currency in much of the world. So any hint of instability or bad news can trigger huge moves in the dollar’s value against other currencies.
Current Challenges and Future Outlook
The USD has enormous historical clout, as well as being the world’s most-widely used currency. Its safe-haven status is increasingly under pressure from competing economic and political forces. The ongoing tensions between President Trump and Federal Reserve Chair Jerome Powell have added to uncertainties surrounding monetary policy decisions.
Even as market participants react to inflation data and hot employment numbers, they look ahead to how those readings will implicate the Fed moving forward. Increasing inflation rates will likely increase market expectations for further rate increases, which would strengthen the positive pressures on the USD. In contrast, if inflation turns out to be low or unemployment rises, the Fed may need to take a more dovish approach.
The US Dollar Index (DXY) recently fell to a three-year low just below 98.00, which indexes the USD against six primary competitor currencies. This decline has raised fears among investors about the dollar’s long-term prospects. Analysts suggest that while short-term volatility is expected, long-term trends will depend largely on how effectively the Federal Reserve manages inflation and employment levels.