The Federal Reserve is moving into an important inflection point. It is firmly focused on the future of the US Dollar in the context of rapidly changing global economic conditions. With the ability to print more Dollars and enact quantitative easing (QE), the central bank is exploring measures to stabilize the financial system. QE is a powerful tool to improve the credit flow massively when the economy gets mired in stagnation. The Fed’s dual mandate of achieving price stability and fostering full employment further complicates its decisions regarding interest rates and monetary policy, which are critical to the value of the US Dollar.
And the US Dollar (USD) is the most traded currency in the world. It accounts for more than 88% of all FX transactions. In addition, it supports an average of $6.6 trillion in daily transactions — a testament to its dominance even in international markets. In light of these developments, sudden shifts in the Dollar’s value can pose serious threats to domestic and global economic stability.
Understanding Quantitative Easing
Quantitative easing is a tool used by the Federal Reserve to pump cash into a floundering economy. Under quantitative easing, the Fed has been purchasing government securities and other financial assets. This strategy reduces interest rates and increases the money supply. This new surge of credit is critically important in times of turmoil when other monetary policy levers cannot be effective.
In times of economic distress, like during a recession, QE can be an extremely important tool in stimulating economic growth. It usually results in a weaker US Dollar because the increased money supply dilutes its value. The relationship between QE and the Dollar is somewhat counterintuitive. While QE is useful in preventing major financial crises, it completely opens the door to long-term inflation and currency devaluation.
The Fed’s ability to print more Dollars during crisis situations allows it to take decisive action when the economy is at risk. Such power brings enormous responsibility. If we print massive amounts of money, it will eventually lead to inflationary pressures that undermine the Dollar’s long-term strength.
The Role of Interest Rates
Interest rates are the Federal Reserve’s principal weapon in the pursuit of its various economic aims. By adjusting rates, the Fed influences borrowing costs, consumer spending, and ultimately, economic growth. When inflation falls short of that 2% target, the Federal Reserve swoops in. If unemployment remains high, they might choose to cut interest rates. This step can provide an immediate boost to economic activity, but it can put a damper on the future value of the Greenback.
When prices increase too fast and inflation is over 2%, interest rates need to be increased in order to be effective. Tightening financial conditions makes dollar-denominated assets more attractive. When investors look to minimize risk and earn strong yields, they move their money into the US Dollar, pushing it higher. This powerful dynamic is a great example of how monetary policy interest rate hikes keep the balance between fighting inflation and supporting strong American economic growth.
The consequences of these decisions reach far beyond US borders, impacting global markets and exchange rates. As the most traded currency, changes in US monetary policy ripple through international economies, affecting trade balances and investment flows.
The Implications for Global Currency Markets
Further, the US Dollar’s standing as the ‘de facto’ currency for the majority of the world’s nations only amplifies its importance in the realm of global finance. It floats as much with local currencies within various countries, but is typically used in contexts for transactions across borders. Second, value movements in the Dollar have far-reaching macro effects on the United States. They are no less damaging to countries that rely on the USD to conduct bilateral trade, or as currency reserves.
When the Federal Reserve does its job poorly and weakens the Dollar with bad policy, it makes American exports more competitive. This increases import costs for American consumers and businesses. Countries dependent on the Dollar for transaction may find their own currencies face the same kind of volatility due to that fact.
Additionally, changes in the Dollar’s value can affect where investors decide to put their money on an international scale. Anticipation of Federal Reserve actions are the biggest drivers for investors, because changes in interest rates or QE programs can determine whether a market goes up or down. A high Dollar encourages enormous capital inflows into US assets. Conversely, a depreciating Dollar encourages investors to seek high growth investment fronts abroad.