At the recent Open Market Committee meeting in June, U.S. Federal Reserve officials predicted that they would keep interest rates close to zero until the end of 2022.
“We’re not even thinking about thinking about raising rates,” said Fed chair Jay Powell. This dovish tone came as the U.S. central bank was expecting the country’s economy to contract by 6.5% this year, before registering a positive growth of 5% in 2021.
“Don’t bet against the Fed,” is an old axiom. To fight the Covid-19 crisis, which abruptly ended the longest economic expansion in the United States on record, the Fed slashed its benchmark interest rates to near zero at an emergency meeting in March, launched a new round of quantitative easing, and set up a lending programme to help small and mid-sized companies.
The Fed was buying Treasuries at a pace of US$75 billion per day not that long ago, boosting its balance sheet sharply to US$7 trillion from some US$4.2 trillion in early March (Figure 1), equivalent to 33% of the size of the U.S. economy in 2019.
Some, including the proponents of the Modern Monetary Theory, may argue that a country with independent monetary policies can print as much money as it needs. But more orthodox economists believe that this could result in out-of-control inflation and a collapse of currency value – “too much money chasing too few goods.”
The reason that the U.S. can print money on such an eye-catching scale, without having to worry too much about provoking a currency crisis, is due to the fact that the greenback remains the dominant reserve currency in the world. Dollar-denominated assets are in high demand, as investors – including individuals, institutions and governments – consider it a safe haven with a reliable store of value, especially during periods of market turmoil.
According to COFER, an IMF database, the U.S. dollar accounted for 61% of the US$11 trillion in allocated foreign exchange reserves in the fourth quarter of 2019. Although this figure is much smaller than the more than 80% seen in the 1970s, it remains well ahead of all other major currencies (Figure 2). The dollar also plays a disproportionate role as a reserve currency, given that the economic size of the U.S. accounts for only 25% of world GDP today.
Many international transactions, whether or not involving a U.S. party, are invoiced in dollars. Virtually all major commodities including petroleum and gold are also priced and settled in the greenback. In other words, participants in global trade and commerce need to hold sufficient dollars for transaction purposes. Around 90% of foreign exchanges trading involves the U.S. dollar.
The dollar’s role as the dominant global reserve currency has given the U.S. many privileges for an extended period of time. For instance, the U.S. government can borrow and pay lower interest than it otherwise would have to, and can draw on surplus savings from abroad easily. The country can in principle print money to reduce its debt burden, and purchase goods and services globally, allowing it to run larger deficits. In addition, the dollar supremacy favours U.S. banks which have better access to dollar funding, making them less vulnerable than their non-U.S. competitors to a disruption in the dollar funding market.
The value and status of a currency depend on the economic and political fundamentals of the issuing economy, as well as trust in its future. There have been debates for some time already on whether the greenback can maintain its supremacy given the persistent twin deficits of the U.S. – its budget deficit and current account deficits – and the resulting huge national debt accumulated.
Recent developments have sparked more discussion on the dollar’s status. For instance, there are questions on the Fed’s independence under political pressure from the White House, and whether its aggressive actions to backstop markets during the coronavirus pandemic would create asset bubbles and fuel wealth inequalities. Some say that a retreat from globalization and the decoupling of the U.S. and China – with both trends appearing to accelerate – may hasten the search for an alternative monetary system which is less dollar-centred.
That being said, there are no real alternatives that have a comparable liquidity as the dollar and a capital market similar in size as the one in the U.S. Major currencies with the potential to challenge the dollar’s status all have their own limitations and problems. Even though there has been a gradual erosion in the dollar’s supremacy as a reserve currency over the past decades, it seems that we still have a long way to go before we are willing to bet against the Fed during financial storms.
Wilson Chong, firstname.lastname@example.org