The US dollar: from Bretton Woods to monetary policy control over exchange rates

What is the US Dollar and Its Importance in Global Markets?

The US Dollar USD forms the backbone of the global monetary system. It is not only the official currency of the United States but also considered the “actual” currency for dozens of other countries around the world. This dominance did not come by chance; since World War II, the British Pound Sterling relinquished its role as the global reserve currency in favor of the US Dollar.

Historically, the dollar was linked to gold for most of its history, and this link remained until the Bretton Woods Agreement in 1971, when the gold standard was abolished and a new exchange system was established. Today, the US Dollar accounts for more than 88% of total global foreign exchange trading, with a daily average exceeding $6.6 trillion according to 2022 data.

Monetary Policy: The Main Tool to Control the Dollar’s Value

The primary factor determining the strength of the US Dollar is the monetary policy formulated by the Federal Reserve. The Fed aims to achieve two simultaneous goals: price stability and controlling inflation, as well as promoting full employment. Its main tool is the interest rate.

When inflation rises above the Fed’s 2% target, the Federal Reserve raises interest rates, which strengthens the dollar. Conversely, when inflation falls below this level or unemployment rises, the Fed may lower rates, which weakens the dollar. In emergency situations, the bank resorts to quantitative easing (QE), which involves printing money and purchasing government bonds to increase liquidity.

Quantitative easing typically weakens the dollar, while quantitative tightening (QT), the opposite process during which purchases and reinvestments are halted, usually strengthens the dollar.

The US Dollar Index Rises with Political Stability

The US Dollar Index (DXY), which measures the dollar’s value against six major global currencies, is moving towards positive levels around 99.50 during Asian session trading. This rise coincided with the end of the longest government shutdown in US history.

On the domestic policy front, President Donald Trump signed the funding bill that reopened the government on Thursday. The House of Representatives voted on the bill with a margin of 222 to 209, supported mostly by Republicans and a limited number of Democrats. This positive development could support the dollar in the short term.

Market Expectations for Rate Cuts in December

The reopening of the government will lead to the release of large amounts of accumulated economic data. Although the White House indicated the possibility of not releasing October employment and consumer price data, analysts expect upcoming economic data to show a slowdown in growth.

This potential slowdown may prompt the Federal Reserve to cut interest rates during the December meeting. Markets are currently pricing in a 64% probability of such a cut, according to CME Group’s FedWatch tool.

Diverging Opinions Among Fed Officials on Monetary Policy

Policy makers within the Federal Reserve are not unified in their views. Fed Governor Stephen Miran described the current monetary policy as too tight, explaining that the slowdown in housing sector inflation reduces price pressures.

Meanwhile, Atlanta Fed President Raphael Bostic expressed a preference to keep interest rates at their current levels until there is a “clear indication” that inflation is returning to the Fed’s 2% target.

Both Neil Kashkari, Alberto Musalem, and Bith Hamek are scheduled to make statements later on Thursday, which could provide valuable clues about future monetary policy directions. Comments leaning toward tightening will boost the dollar, while more pessimistic views could pull it down.