Top Dollar

Story Highlights:

• Though the dollar has weakened this year relative to other major currencies, it’s a mistake to equate exchange rate weakness with declining international status.
• Recent weakness is largely a result of diverging monetary policies in the US and abroad—relative monetary policies have a big influence on short-term exchange rate moves.
• Even if the dollar has been relatively weak, US economic recovery has been much stronger than countries with stronger currencies.
• Some foreign governments may increase or decrease their dollar reserves here or there, depending on diversification or exchange needs, but the fact is the world is pretty entrenched in dollars.

Headlines barking the imminent demise of the dollar are simply barking up the wrong tree. Though the dollar has weakened this year relative to other major currencies, it’s a mistake to equate exchange rate weakness with declining international status.

The US dollar has long enjoyed a happy reign as the world’s dominant reserve currency. It is the leading (and preferred) transaction currency in foreign exchange markets, it’s used to buy and sell goods (including most major commodities, like gold and oil) worldwide, and dollars comprise the bulk of most countries’ foreign currency reserves. But some believe the dollar is precariously perched atop the currency hierarchy, raising fears the world may soon move away from the dollar as dominant reserve and invoice currency.

Complicating the story seems to be the recently weakening dollar. However, recent weakness is largely a result of diverging monetary policies in the US and abroad—not an indication the dollar’s on its way out. Relative monetary policies have a big influence on short-term exchange rate moves. Exchange rates are driven by currency supply and demand. Loose monetary policy ensures an ample supply of cheap money and deters investors seeking higher yield, typically weighing in the associated currency. Tighter monetary policy means a tighter supply and higher rates more attractive to investors, which often moves exchange rates higher.

US monetary policy remains very loose, with the Fed’s second round of quantitative easing (QE2) injecting $600 billion into the economy. On the other hand, the Bank of England (BOE) and European Central Bank (ECB) appear on the verge of raising rates (possibly as soon as April for the ECB)—not surprising given inflation in these areas are trending higher than in the US. In Japan, capital repatriation following the tragic earthquake and tsunami has been driving the yen higher. These factors have contributed to dollar weakness, but a weaker dollar isn’t a negative for the US economy. On the contrary, the US economy has recovered more quickly than Europe, the UK, or Japan.

Other currencies or synthetic currencies, like the International Monetary Fund’s Special Drawing Rights (comprised of 41.9% US dollars), have been suggested as candidates to supplant the dollar as reserve currency—but all have their problems. First and foremost, capital markets in these regions can’t compete with the US in terms of depth, liquidity, and diversity. And when nervous investors seek safety above all else, like in 2008, they inevitably turn to the dollar. Some foreign governments may increase or decrease their dollar reserves here or there, depending on diversification or foreign exchange needs, but the fact is the world is pretty entrenched in dollars, meaning any move away from it as a reserve currency would be a long, slow process—despite what rhetoric may imply.

Fretting over the dollar’s fate isn’t new, and a bout of relative dollar weakening isn’t cause for alarm. Monetary policy can continue to diverge, further weakening the dollar relative to the euro or sterling—or more robust growth in the US can also lead to tightening here, possibly lifting the dollar. However, neither should impact the dollar’s status as currency reserve—on that front, for now, the dollar is still tops.