The US Dollar, by a wide margin, is the most important global redenomination currency. It is responsible for greater than 88% of all the world’s foreign exchange transactions. The Dollar provides the U.S. with extraordinary power over the global financial system. It fuels the global daily average of $6.6 trillion in transactions. This article explores the evolution of the US Dollar, its significance in global trade, and the mechanisms employed by the Federal Reserve to maintain its value and stability.
Following World War II, the US Dollar replaced the British Pound as the world’s main reserve currency. This transition represented a momentous re-alignment in the balance of global economic power. The Dollar’s position was further solidified by its gold backing, which continued until 1971. This system of fixed exchange rates known as the Gold Standard was terminated with the Bretton Woods Agreement. Ever since then, the Federal Reserve has been the most consequential actor in establishing the long-entrenched monetary policy that has underpinned the Dollar’s global primacy.
The Role of the Federal Reserve
The Federal Reserve, the central banking system of the United States, is tasked with two primary mandates: achieving price stability and fostering full employment. Each of these goals is critically important to the American economy. They further keep the world’s confidence in the US Dollar as the global currency.
The Federal Reserve strives to balance these goals, and uses a number of tools to do so. Changes to interest rates are the most powerful tool at its disposal. When price growth accelerates past the Fed’s goal of 2 percent, it usually tries to correct that by increasing interest rates. This move usually serves to strengthen the Dollar’s value.
If inflation falls below 2% or unemployment rises sharply, the Fed can start reducing interest rates. This step is intended to weaken the Dollar. When a country lowers interest rates, it generally causes lower returns on investments in that currency.
In the most extreme cases, economic circumstances can turn fatal. In addition, the Federal Reserve can decide to print additional dollars and pump liquidity into the financial system. This targeting approach is consistent with a new, broader monetary policy strategy that encompasses QE.
Understanding Quantitative Easing
Quantitative Easing is the Federal Reserve’s term for its efforts to put more credit into a moribund financial system. By buying bonds from the federal government and other financial institutions, QE is meant to drive interest rates down and spark economic activity. This policy has a very favorable effect on the US Dollar. Greater liquidity increases investor confidence and powers greater economic development.
QE is not without its concerns. Critics, including some who once championed QE and other unconventional policies, contend that all of this money printing creates inflationary pressures down the road. The ramifications of these policies stretch beyond our own borders, affecting global markets and trade patterns.
The Federal Reserve’s ability to do QE is a testament to its independence and nimbleness to react to changing economic circumstances. Especially during periods of increased trade pressure or geopolitical risk, these important measures increasingly help prop up weak economies. Recent escalations, including those described by the International Monetary Fund (IMF), demonstrate exactly why these actions are vital for the US economy and the global marketplace.
“Swift escalation of trade tensions and high uncertainty expected to have significant impact on growth in all regions.” – IMF
The Mechanics of Quantitative Tightening
In QT, the Federal Reserve stops buying bonds and ceases reinvesting the money from maturing bonds into new bonds. This process generally helps to remove liquidity from the market and can have mixed impacts on the US Dollar’s value.
QT usually happens when economic data starts to show that inflation has been tamed and full employment has been achieved. As liquidity decreases, interest rates may rise, potentially strengthening the Dollar. Those actions must be judiciously calibrated to avoid over constricting economic growth or pushing the unemployment rate up too far too fast.
The tension between needing to implement QE and needing to do QT illustrates the complicated real-time dance between deteriorating economic conditions and hawkish monetary policy. The Federal Reserve is constantly evaluating new economic indicators to figure out how to best move forward.