Reports of the dollar’s demise are greatly exaggerated

The recent sharp depreciation of the U.S. dollar has led to concerns that it may lose its role as the main global reserve currency. After all, in addition to the Federal Reserve’s aggressive monetary easing—which threatens to debase the world’s key fiat currency even further—gold prices and inflation expectations have also been rising.

But, to paraphrase Mark Twain, reports of the dollar’s early demise are greatly exaggerated. The dollar’s recent weakness is driven by shorter-term cyclical factors. In the long run, the situation is more complicated: the dollar has both strengths and weaknesses that may or may not undermine its global position over time.

Chief among the short-term negative factors is the Fed’s ultraloose monetary policy. With the United States monetizing ever-larger budget deficits, the Fed’s approach looks more accommodative than that of most other major central banks.

The dollar tends to weaken during risk-on episodes, and vice versa. That is why its value peaked during the February-March panic over COVID-19, and then weakened from April onward as market sentiment recovered.

Moreover, the Fed’s activation of currency swap lines with other central banks eased the dollar illiquidity that had been pushing the exchange rate higher earlier in the crisis. Now, a flood of global dollars is putting downward pressure on the U.S. dollar.

Dollar could strengthen
Even in the short run the dollar could strengthen again if—as the latest global growth data suggest—a V-shaped recovery stalls into an anemic U-shaped recovery, let alone a double dip, if the first pandemic wave is not controlled and a second wave kills the recovery before effective vaccines are found.

In the medium to long term, multiple factors could preserve the dollar’s global dominance. The dollar will continue to benefit from a broad-based system of flexible exchange rates, limited capital controls, and deep, liquid bond markets.

More to the point, there simply is no clear alternative currency that could serve as a broad unit of account, means of payment, and stable store of value.

Furthermore, despite its pandemic travails, the potential annual US growth rate, at around 2%, is higher than in most other advanced economies, where it is closer to 1%. The U.S. economy also remains dynamic and competitive in many leading industries, such as technology, biotech, pharmaceuticals, health care, and advanced financial services, all of which will continue to attract capital inflows from abroad.

Nouriel Roubini says reports of the dollar’s demise are greatly exaggerated, MarketWatch, Aug 25