Will Inflation Destroy the Credibility of the U.S. Dollar?

The US Dollar is widely considered as an indispensable part of international trade. It’s the pillar of the Bretton Woods system. Since the end of WWII, the U.S. Dollar emerged as a standard medium of exchange for international trade, which was only further entrenched after the collapse of the Soviet Union, the fall of the Iron Curtain and end of the Cold War. The Bretton Woods system came to an end after the termination of the convertibility of the Dollar to Gold in 1971, rendering the Dollar a fiat currency. In recent years, the U.S. economy has been losing the dominance it once had in its share of global GDP. 

The COVID-19 pandemic acted as a catalyst for this changing dynamic. The most important factor for a financial powerhouse is the entity's share in the world as a reserve currency. Historically, the Dutch East India Company made the Guilder an important player in global trade, a position which was then passed to the British Pound Sterling, followed by the U.S. Dollar. The pandemic and the reckless money printing by the Federal Reserve will and has caused irreversible damage to the U.S. economy. 

 

The critical reason for the Dollar's importance as a reserve currency is because of the confidence investors, bankers and traders put in it. It is the standard currency for conducting almost all transactions, as mentioned earlier. Right now, the Dollar is the best performing currency relative to global foreign exchange rates. This can be attributed to a variety of geopolitical risks within the global economy such as China’s zero Covid policy and its troubled real estate sector. These events have driven investors to safe-haven investments. The problem is, what happens if the very value of this medium of exchange is under threat? There will be an erosion of faith in the currency. If these volatilities are to be realised, it would cause an exodus of investments away from the Dollar, propelled by behavioural economics and high frequency trading that could lead to its value crashing. It should be noted this is an extreme scenario. A key reason for considering the possibility of Dollar ‘hyperinflation’ is the money printing of the past 24 months, which has inserted a staggering 80% of all Dollars ever created into circulation. Inflation is not instantaneous, it takes months, sometimes even years. A cause for this delay is the lack of ‘monetary velocity’. Monetary velocity is the rate of transactions that occur within an economy, put more simply, the amount of money that changes hands. The pandemic abruptly halted this monetary velocity, but this was only temporary. We now see inflation rates of over 8%. The White House blames this on the Russia-Ukraine war. The war has indeed exacerbated the rise in commodities prices and even inflation to an extent but this trend preceded the invasion. Even with the Federal Reserve raising interest rates, it is not nearly enough to retract funds already in circulation.

In the coming months, inflation is most definitely set to worsen and there is the possibility of the US economy slipping into recession. Although bears often have an alarmist tendency of screaming ‘perpetual crisis’, upcoming quarters are not viewed with a positive outlook. 

The Chinese Renminbi had been referred to as a competitor that could topple the status the Dollar currently holds. This is questionable. Although the Chinese economy is the closest competitor to the United States, this cannot be said for foreign exchange dominance. The Renminbi does not possess nearly the same level of investor confidence that the Dollar does. The currency's volatility is also problematic with Beijing restricting convertibility for its citizens and diaspora. In the long run, the prospects look a lot more decentralised, meaning instead of the Dollar being completely replaced, there is a higher probability of a basket of currencies emerging that could include alternative currencies such as Renminbi and the Euro. 

Previous
Previous

Russia attacks Ukrainian Energy Infrastructure

Next
Next

State of supply: uranium in Europe