The US Dollar (USD) is having a pronounced recovery. This is against a backdrop of investor confusion over ping ponging tariff headlines and the administration’s overall economic playbook. The Federal Reserve (Fed) is in the process of reshaping its monetary policy framework. At the same time, the chatter on market discussions is all abuzz with QE and interest rate hikes. This article explores the nuances of how each one of these factors affects the USD. While focusing on this past chapter, it provides an analysis of key economic indicators.
This strategy proved critical during the Great Financial Crisis of 2008. To counter this, the Fed is literally printing trillions more dollars to inject liquidity into the system. They are likely using this money to purchase US government bonds from the banks and other financial institutions. This targeted intervention is an immensely popular and impactful tool to further economic security. It’s critically needed at times when inflation has dropped below the Fed’s floor of 2% or in moments when unemployment spikes.
The Role of the Federal Reserve
The Federal Reserve’s dual mandate is to promote both price stability and full employment. To accomplish these objectives, it manipulates the short-term interest rate as its main weapon. When inflation remains persistently below their 2 percent target, the Fed responds. If they see unemployment rates start to rise too fast, they might decide we need lower interest rates. This decision almost always lowers the worth of the Greenback. Consequently, for investors in search of predictable, strong returns it’s less attractive.
When inflation exceeds the Fed’s 2% target—invisible tax—the Fed can increase interest payments to slow down price growth. Those moves usually support the USD, because rising rates draw in foreign capital and boost demand for dollar-denominated assets.
“I expect the risk of recession would outweigh the risk of escalating inflation, especially if the effects of tariffs in raising inflation are expected to be short-lived,” – Christopher Waller
I can’t understate the importance of monetary policy’s role in swaying the USD. Global markets are watching intently to see what the Fed does. Because any change in interest rates can cause an instant reaction in forex value.
Historical Context of the US Dollar
One of the world’s oldest fiat currencies, the US Dollar, has served as America’s official currency since 1792. In the meantime, it has just as easily morphed into the ‘de facto’ currency in most other countries. After World War II, it supplanted the British Pound as the world’s reserve currency. This notion has held this position because of its common acceptance as true and the faith that people have in its somewhat precarious stability.
Without getting too deeply into monetarism, historically the USD was backed by gold. The Bretton Woods Agreement of 1971 brought an end to the Gold Standard. Since that time, the dollar has been a fiat currency. Its worth is not based on any tangible goods, but rather on supply and demand and the confidence individuals have in the government that creates it.
Because in recent years, changes in the dollar’s value have been overwhelmingly driven by QE policies. This process always results in a weaker dollar, as the new liquidity introduced into the market reduces the dollar’s purchasing power. Quantitative Tightening (QT) though, is the opposite of QE. It means the Fed halting bond buying and deciding against reinvesting in maturing bonds, which generally serves to stabilize or increase the value of the USD.
Current Economic Indicators
As of 2022, the USD remains uncontested as the world’s most traded currency. It represents more than 88% of all foreign exchange turnover. Daily transactions exceed $6.6 trillion, illustrating its essential value to global trade and finance. For all this dominance, trade war tariff talks and waning global economic confidence still threaten the dollar’s longer-term direction.
According to analysts, this uncertainty is largely the result of current tariff policies and their erratic implementation driving market volatility. One prominent financial institution commented on these developments:
“With every U-turn in Trump’s ‘dealmaking’, the US president destroys further planning security and even more trust, which is why we ultimately do not expect any significant recovery in the US dollar as long as this uncertainty persists for all participants in world and economic affairs.” – Analysts at Commerzbank
Investors are especially concerned about how these tariffs will affect inflationary pressures. Tariffs have the potential to cause lasting increases in inflation. Consequently, the Fed may need to follow with higher interest rates, making the connection between monetary policy and currency value rather complicated.