The US Dollar (USD), the official currency of the United States, has been in apparent freefall over the past couple of months. Economists, as well as those who trade in the market, are alarmed by this drop off. It is increasingly enmeshed with bigger economic threats, which compounds the concern. As the world’s most actively traded currency, the USD accounts for more than 88% of all foreign exchange trading. Its volatility can have monumental impact on international markets. Meanwhile, recent data indicates that the average daily transaction volume with the USD is approximately $6.6 trillion. This underscores for the umpteenth time the currency’s important strategic, political, and security influence globally.
The Federal Reserve (Fed), as the primary monetary authority, plays a critical role in regulating the USD’s value through its dual mandate: to achieve price stability and foster full employment. By increasing or decreasing interest rates, the Federal Reserve can keep inflation within acceptable levels and ensure sustainable economic expansion. Consequent challenges, like inflation fears and global unrest, are forcing critics to question the Fed’s policies even further. These concerns are driving the effect on the dollar.
The Significance of the US Dollar
The US Dollar is the official currency of the United States. Moreover, it functions as the ‘de facto’ currency for dozens of other countries worldwide. In many jurisdictions, the USD flows in parallel with local currencies, a testament to its power as a stable store of value and safe medium of exchange.
Historically, the USD replaced the British Pound as the world’s reserve currency during the aftermath of World War II. This change made the dollar the bedrock of global commerce and capital flows. Moreover, it allows the dollar to continue to wield outsized power in global markets. Additionally, countries that rely on the USD for international trade have strategic interests to protect. It’s continued stability that fosters smart economic competition and lucrative trade deals around the globe.
The dollar’s exceptionalism is manifest in its role in foreign exchange markets. With its mind-boggling 88% share of global transactions, it reminds us just how important a role the dollar plays in helping the world trade. The network effects of the USD’s extensive international adoption make its advantages particularly ironic. It has been a refuge in times of economic turmoil.
The Role of the Federal Reserve
The Federal Reserve has an undeniable power over the USD. It employs a wide range of unconventional monetary policy tools to do so. The Fed’s dual mandate Component one of the Fed’s dual mandate is to control inflation. To achieve these goals, it raises or lowers interest rates depending on the economic situation.
When inflation goes above its target rate of 2%, the Fed in the past has raised interest rates aggressively. This move serves to bolster the USD by increasing the currency’s appeal to investors looking for better returns. So, whenever unemployment rises, or inflation falls below the Fed’s 2% target, the Fed can be expected to lower interest rates. This action is intended to create economic activity and can sometimes result in a weaker dollar.
Or, second, in extreme environments where even this basic formulation of monetary stimulus appears to not be doing the trick, the Fed can turn to quantitative easing (QE). This quasi-political process consists of adding to the money supply in order to boost the flow of credit, or liquidity, in a frozen financial system. One effect of QE is a weaker dollar, as discussed above the new currency increases the supply.
Current Economic Climate and Impact on the Dollar
With increasing economic risks, recent developments have put the future trajectory of the US Dollar into question. The US Dollar Index (DXY) fell to 99.50 in recent trade, a sign of translating fears about US economic prospects. Analysts point to former President Trump’s tariff policy as the chief cause for this drop. They caution that increasing trade conflict could have long-term effects on the US economy.
The recent trade war between the United States and China has made these fears even worse. Consequently, currency markets all around the globe are currently seeing extraordinary levels of volatility. The USD Index just endured an even longer losing streak of three trading days in a row. This drop underscores investor fears over potential retaliatory action from China.
With economic indicators staying unpredictable, participants in the market are on their toes for signs of a new direction for Federal Reserve policy. Walking that tightrope of curbing inflation without spiking unemployment is no easy feat. One wrong move might jeopardize the strength of the dollar and the long-term health of the economy.