The US Dollar Index (DXY), which evaluates the strength of the US Dollar (USD) against six major currencies, has reversed recent losses and is now trading around 101.50 during Asian trading hours on Friday. Market participants are keenly awaiting the release of the Michigan Consumer Sentiment Index later in the day, which may provide insights into American consumer confidence.
Support for the Greenback has been derived from increasing expectations of an interest rate hike by the Federal Reserve (Fed). The CME FedWatch tool indicates that traders are currently anticipating a 63.4% likelihood of a rate increase during the Fed’s upcoming meeting scheduled for September 15-16. This cautious optimism is further bolstered by accelerating inflation data, as evidenced by the headline Personal Consumption Expenditures (PCE) Price Index, which rose to 4.1% year-over-year in May, up from 3.3% in April. This marks the first time in three years that the headline index has surpassed 4.0%, a movement largely linked to rising energy prices attributed to ongoing conflicts in the Middle East.
Additionally, the Fed’s preferred inflation measure, the core PCE index, increased to 3.4% year-over-year compared to the previous figure of 3.3%. This represents the highest annual core reading since October 2023. Scott Anderson, Chief US Economist at BMO, has pointed out that the elevated PCE inflation will likely keep the Fed in a cautious stance, with potential for future rate hikes still on the table. He cautioned that persistent service inflation might not be easily mitigated by a drop in energy prices, leading to continuous debate among policy hawks and doves regarding the appropriate monetary response.
In terms of the US Dollar itself, it serves not only as the official currency of the United States but also functions as a ‘de facto’ currency for many other nations, where it is commonly used alongside local currencies. The USD is regarded as the most heavily traded currency globally, representing over 88% of foreign exchange transactions, with volumes averaging $6.6 trillion daily as of 2022. Post-World War II, the Dollar succeeded the British Pound as the world’s reserve currency, a status it has maintained since the end of the Gold Standard following the Bretton Woods Agreement in 1971.
The value of the US Dollar is primarily influenced by monetary policy set by the Federal Reserve, which aims for price stability and full employment. When inflation rates soar above the Fed’s 2% target, the central bank is inclined to raise interest rates, which typically supports the value of the USD. In contrast, lower inflation or high unemployment may prompt rate cuts that exert downward pressure on the Dollar.
In extreme circumstances, the Federal Reserve might resort to printing more Dollars through a process called quantitative easing (QE). This strategy is intended to enhance credit flow within a stagnant financial system and serves as a last resort to combat economic downturns, such as the credit crunch experienced during the 2008 financial crisis. Conversely, quantitative tightening (QT), which involves halting bond purchases and not reinvesting the principal from maturing bonds, generally has a positive impact on the US Dollar.
