Strong and stronger: That’s the story of the US dollar’s seemingly unending upward trajectory. Because the United States relies less on manufacturing than do other nations, the American economy has become increasingly insulated from the outside world, while the dollar continues its reign as the world’s currency of choice in trade, banking and foreign exchange. Economists Ozge Akinci, Gianluca Benigno, Serra Pelin and Jonathan Turek provide an expert overview of how hawkish Federal Reserve policy fortifies this feedback loop: The dollar buffers the US economy while emerging markets suffer the knock-on effects.
- The US dollar rules the global monetary system.
- The dollar imperium results from the global economy’s current state of affairs.
- The American economy, while increasingly global, is growing less exposed to foreign developments.
The US dollar rules the global monetary system.
Dollar usage in the international monetary system occurs across domains that are larger, in the aggregate, than the American economy is within the world’s economy. The US dollar plays an outsized role in trade invoicing, credit extensions and global value chains. Some 60% of global foreign currency reserves are held in US dollars. Foreign investors hold about one-third of outstanding US treasury instruments. Almost two-thirds of global and overseas foreign currency liabilities are denominated in US dollars. Approximately 40% of global payments occur in dollars.
“We describe the mechanism through which the dollar acts as a procyclical force, generating what we dub the ‘Dollar’s Imperial Circle,’ where swings in the dollar govern global macro developments.”
At the same time, the US economy’s exposure to world economic events is less than that of its trading partners. This means that the dollar is less susceptible to events overseas. The perverse outcome is that the dollar strengthens to the detriment of global manufacturing, in a self-reinforcing virtuous circle.
The dollar imperium results from the global economy’s current state of affairs
The global economy is grouped into three camps: the United States, advanced economies and emerging markets. Countries in emerging markets establish export prices in US dollars. Advanced economies, by contrast, set export prices in their own currencies. A stronger dollar puts emerging market economies at a disadvantage. These same countries often have to finance inputs used for the production of goods with US dollars. These two factors hurt the manufacturing sectors in developing markets.
“In the final turn of our mechanism, given that the US economy is relatively less exposed to global developments, the contraction of global manufacturing and global trade is associated with a further strengthening of the dollar, reinforcing the circle.”
More restrictive US monetary policy initiates “the Imperial Circle” process, as a rising dollar constricts manufacturing around the world, limiting emerging economies. This contraction affects American manufacturing due to a falloff in overseas demand for US goods. Commodity prices decline as global trade slows. Because the United States faces scant macroeconomic impacts from these global developments, the dollar strengthens further.
The American economy, while increasingly global, is growing less exposed to foreign developments.
A strong dollar leads to slower global trade and growth. The dollar soars as the US economy’s vulnerability to global trade declines, building a stronger dollar.
“As the US economy is less exposed to global developments, the dollar will benefit in relative terms from a worldwide economic decline, reinforcing the circle.”
Since the 1970s, trade as a share of US GDP has declined, while in China, the euro area and many other countries, trade as a share of GDP has grown and even doubled. America’s declining exposure to the global economy, coupled with the dollar’s dominance in international trade and finance, assures the dollar’s self-reinforcing procyclicality.
About the Authors
Ozge Akinci and Gianluca Begnino are with the Federal Reserve Bank of New York. Serra Pelin is with the University of California, Berkeley. Jonathan Turek is with JST Advisors.