The US Dollar (USD) is the official currency of the United States of America, which consists of 50 states. Yet, it is a critical linchpin of our global economy. The USD further acts as the ‘de facto’ currency in many countries outside of the United States’ national borders. It travels in tandem with local reporting from communities around the country. This widespread acceptance underscores the dollar’s dominance, as it remains the most heavily traded currency worldwide, accounting for over 88% of all global foreign exchange turnover.
On a nominal basis, each day the USD underlies an astounding $6.6 trillion transactions. This underscores its indispensable place at the center of international trade and finance. After WWII, the dollar exploded to become the first and only true global reserve currency. It even managed to surpass the British Pound in this major conversion. In the past, the USD was gold-backed. After the valuing agreement of Bretton Woods in 1971, this standard was relinquished and the dollar moved towards fiat money.
The Role of the Federal Reserve
The Federal Reserve (or the ‘Fed’ for short) is considered to be the main institution controlling monetary policy in the United States. Its dual mandates direct it to accomplish both price stability and full employment. The Fed is not a passive actor, waiting to see the results of changes in the economy. These are raising and lowering interest rates, as well as doing QE and QT.
Through QE, the Fed can add liquidity to the economy by buying up US government bonds from financial institutions. This process by definition increases the money supply and puts downward pressure on the USD. In contrast, QT is the cessation of bond-buying. It equates to not reinvesting the principal from maturing bonds which can help tighten the money supply and strengthen the dollar.
The impact of these policies is felt well beyond American shores. Changes in interest rates and monetary policy have a significant and adverse effect on foreign exchange markets. They affect the performance of other currencies against the USD. Investors hang on every Fed statement and report to inform themselves about the likely effects on their investments, investment strategies, and expectations for future repayment.
The Global Impact of the US Dollar
As the world’s premier reserve currency, the USD is uniquely positioned to dominate international transactions. Most of the rest of the world decides to keep their reserves in dollars, making US trade and investment much easier. This impacts even more on countries where local currencies are volatile or thinly traded.
Besides being the favored reserve currency, the dollar enters the daily transactions of most countries. In fact, over a dozen economies adopt the USD together with their national currency to pursue monetary and financial stability as part of their system. In short, this negotiation works as an effective hedge against inflation and economic instability.
The US Dollar Index (DXY) is the most well-known gauge of dollar strength. Specifically, it uses its broad trade-weighted index, which measures the dollar against a basket of six major currencies. Investors and analysts watch DXY changes with bated breath. These changes are symptomatic of larger economic trends and ongoing economic uncertainty as well as a major shift in market sentiment.
The Challenges Ahead for the Dollar
While the USD is on top today, there are very real threats that could undermine its status in global finance and reshape its future. The growing competition from emerging currencies and digital assets presents another risk. Competitor countries such as China are working aggressively to encourage use of their currencies for international trade. Efforts that, if successful, would erode the USD’s dominance over time.
Further, geopolitical competition and trade conflicts could undermine confidence in the dollar’s preeminence as a convenient unit of account. Central banks across the globe are all keeping a close watch. They are all actively diversifying their reserves to reduce the risks of holding large amounts of USD.
These dynamics have long term implications and might reconfigure the ways countries will engage with the dollar in the future. Countries have been hard at work developing substitutes and currencies circumventing the dollar entirely for their international trade. The future of the USD depends on its willingness and ability to respond to changing global economic realities.