The US dollar will almost certainly remain the world's most important reserve currency for the foreseeable future but the lack of a ready substitute does not mean the dollar's current position is entirely assured, says Fitch Ratings in its latest Global Perspectives commentary.
No other currency offers the same set of advantages to money managers, including central banks, or is as deeply embedded in the global financial system. Crucially, the dollar is underpinned by the fact that the US Treasury market is the world's largest and most liquid for risk-free assets, and the Federal Reserve operates independently of government with respect to the market, and in implementing policy more broadly.
Calls for the dollar's displacement were relatively infrequent - although not entirely absent - when US monetary policy was exceptionally accommodative in the aftermath of the global financial crisis. That changed in mid-2013 when the Federal Reserve announced it would begin to slow its asset purchases, causing considerable turmoil in emerging markets (the "taper tantrum") and appeals to the Fed for greater consideration to be given to the international implications of its policy decisions. The Fed now appears poised not only to continue with policy interest rate hikes that began in December 2015, but to also consider the pace and magnitude of eventual balance-sheet reductions.
Perhaps the most plausible scenario for the dollar being meaningfully displaced does not begin with the emergence of a viable alternative, but rather it being undermined at home.
Two pieces of legislation currently working their way through Congress are the Federal Reserve Transparency Act (FRTA) and the Financial Choice Act (FCA).
The first would allow the Government Accountability Office to audit the monetary policy decisions of the Fed and make subsequent recommendations for administrative or legislative actions.
The second would restrict the Fed's ability to provide financial sector support to avert or address a crisis, and empower a commission to review and recommend changes to the Fed's operations, as well as to consider a rules-based rather than discretionary monetary policy framework.
It is the unambiguous intention of these legislative initiatives to curtail the independence of the Fed and allow for greater congressional oversight of monetary policy as well as the Fed's regulatory decisions and interventions related to financial stability.
If implemented, the proposals would diminish the appeal of the dollar as a reserve currency over time. Investors considering dollar assets and other dollar exposures would weigh the risk of political interference in monetary policy decisions and the possibility of the Fed's remit being broadened to include congressional priorities such as indirect funding of infrastructure investment. There may also be concerns about episodes of financial sector stress being deeper and more prolonged if the Fed's policy response options were explicitly limited.
Parties in favour of the FRTA and FCA might argue that the risks identified by those concerned about the Fed's independence - and, incidentally, the dollar's global role - are, in fact, the purpose of the proposed legislation, and that the overall economic interests of the US would be better served by their implementation. The debate is unlikely to end soon no matter the fate of the FRTA and FCA.
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So Fitch is warning that if the world is granted more transparency into what The Fed does then that could end US hegemony? Just lucky that we elect the people who run what appears to be the world's most important institution... oh wait.
As we noted previously, US global geopolitical dominance is on the wane – driven on the one hand by the historic rise of China from its disproportionate lows and on the other to a host of internal US issues, from a crisis of American confidence in the core of the US economic model to general war weariness.
This is not to say that America’s position in the global system is on the brink of collapse. Far from it. The US will remain the greater of just two great powers for the foreseeable future as its “geopolitical multiplier”, boosted by its deeply embedded soft power and continuing commitment to the “free world” order, allows it to outperform its relative economic power. As America’s former Defence Secretary, Chuck Hagel, said in 2014, “We (the USA) do not engage in the world because we are a great nation. Rather, we are a great nation because we engage in the world.”
Nevertheless the US is losing its place as the sole dominant geopolitical superpower and history suggests that during such shifts geopolitical tensions structurally increase. If this analysis is correct then the rise in the past five years, and most notably in the past year, of global geopolitical tensions may well prove not temporary but structural to the current world system and the world may continue to experience more frequent, longer lasting and more far reaching geopolitical stresses than it has in at least two decades. If this is indeed the case then markets might have to price in a higher degree of geopolitical risk in the years ahead.