The US dollar is losing its appeal as the Federal Reserve prepares to slash interest rates in the face of a slowing economy and rising inflation.
The greenback has fallen nearly 2% this year against a basket of six major currencies and is close to its lowest level since July. The dollar index was at 101.54 on Wednesday, just above the five-month trough of 101.42 it hit last week.
The dollar’s weakness is mainly driven by the market’s expectation that the Fed will start cutting rates as soon as March 2024, and continue to do so throughout the year. According to the CME FedWatch tool, the market is pricing in a 79% chance of a rate cut in March, and as much as 153 basis points of cuts for the whole year.
Why The Fed Is Under Pressure
The Fed has been hiking rates since 2015 to combat inflation and support the economy, which has been growing steadily for the past decade. However, the Fed now faces a dilemma: how to balance the risks of a slowing economy and rising inflation.
The US economy has been showing signs of weakness in recent months, as trade tensions, geopolitical uncertainties, and a partial government shutdown have taken a toll on consumer and business confidence. The latest data showed that the US economy grew by 2.6% in the fourth quarter of 2023, down from 3.4% in the previous quarter. The Fed’s own projections indicate that the growth rate will slow further to 2.3% in 2024 and 1.9% in 2025.
At the same time, inflation has been creeping up, partly due to higher oil prices and a weaker dollar. The Fed’s preferred measure of inflation, the core personal consumption expenditures (PCE) index, rose by 2.2% in November, above the Fed’s 2% target. The headline PCE index, which includes food and energy, jumped by 3.1%, the highest since 2011.
The Fed has to decide whether to cut rates to stimulate the economy and prevent a recession, or keep rates steady, or even raise them to curb inflation and preserve the dollar’s value. The Fed’s decision will have significant implications for the global financial markets, as well as the US political landscape ahead of the 2024 presidential election.
How the World Reacts: The Global Impact
The dollar’s decline has been a boon for other currencies, especially the euro, which has gained nearly 3% this year and is on track for its third consecutive month of gains. The euro was trading at $1.1034 on Wednesday, close to its four-month high of $1.1045.
The Japanese yen, however, has weakened by 0.17% to 142.64 per dollar and is set to lose 8% this year. The yen’s weakness is partly due to the market’s speculation that the Bank of Japan (BOJ) will soon exit its ultra-easy monetary policy, which has kept interest rates at or below zero and expanded the central bank’s balance sheet to unprecedented levels. The BOJ has been under pressure to normalize its policy as the Japanese economy has shown signs of improvement and inflation has edged up.
The Australian dollar and the New Zealand dollar, both sensitive to global trade and commodity prices, have also benefited from the dollar’s weakness and the easing of trade tensions between the US and China.
According to a report by Reuters, the Aussie, and the Kiwi, both hit a five-month high on Wednesday but pared some of their gains later. The Aussie was at $0.6822, while the Kiwi was at $0.6321.
The dollar’s fate in the coming year will depend largely on how the Fed and the US economy perform, as well as how the rest of the world copes with the challenges and opportunities of a changing global order.
