How the Fed Impacts the US Dollar

Currency plays a big role in economic growth, inflation, and the price of consumer goods. One of the most important factors influencing the value of the US dollar is the Federal Reserve’s monetary policy.

By law, the Fed is mandated to conduct monetary policy so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. One of the ways the Fed carries out their mandate is by adjusting interest rates.

Typically, when inflation rises too quickly and goes above the Fed’s 2% target, the central bank would increase interest rates, which tends to strengthen the dollar, particularly when other central banks are not raising interest rates. When inflation falls below the target or if the unemployment rate is too high, the Fed would lower interest rates, which tends to weaken the dollar, particularly when other central banks are not lowering interest rates.

US dollar remains strong despite cracks over the summer

The US dollar index – which measures the US dollar against six major foreign currencies – fell over the summer. But the factors that weighed on the dollar mostly reversed not long after.

First, the stronger-than-expected September jobs report likely led to the 25 bps interest rate cut by the Fed in November (as opposed to the prospect of a 50 bps cut). Goldman Sachs Research currently expects consecutive rate cuts in December, January, and March, but with the two final cuts to come later in June and September.

Second, Goldman Sachs Research forecasts the US economy to grow at 2.8% in 2024 on an annual basis and 2.5% in 2025, a faster pace than most other major economies.

This economic backdrop gives reason for investors to believe there is a return to “US exceptionalism.”

US exceptionalism keeps the dollar in high demand

According to Goldman Sachs Research, the US dollar has been overvalued for almost a decade, which is why most investors have been calling for the dollar to fall. Typically, when the Fed cuts rates, the dollar value would decrease. But that drop was short-lived, as the dollar returns to its persistently high valuation. One reason is that the market believes in US exceptionalism, and the recent strong economic and job reports arguably support that idea.

Goldman Sachs Research notes for the dollar to go down more substantially, investors will need to find better capital return prospects in other non-USD markets. While there are prospects, no other markets are currently close to being able to replace the US dollar in the global financial system.

For one, the US dollar is considered the currency of choice for international trade and takes up the majority of global central bank reserves. Commodities such as oil are primarily bought and sold in US dollars. Second, major economies peg their currencies to the dollar. The US also boasts having the world’s largest debt market – or US treasuries – which currently totals around $26 trillion as of August 2024.

Foreign investors tend to seek the relative safety and yield of US Treasuries, as well as long-term returns via US Foreign Direct Investment (where foreign companies or individuals invest in the US). These inflows, combined with the strong relative market performance of US assets, have resulted in a sharp rise in the share of US assets in global portfolios. According to International Monetary Fund data, the share of cross-border portfolio investment held in US assets rose from about 20% in 2013 to nearly 30% today.

Three factors that could impact the US dollar

Goldman Sachs Research expects the US dollar to remain strong in the near-term, as US equity markets increasingly anticipate a better US economic growth outlook than competitors such as European equities. They believe the commitment from the Fed to continue its rate cut cycle should keep rate volatility and recession odds low.

Here are three factors our analysts are watching that could impact the value of the US dollar:

1. US exceptionalism: The incoming data suggests that US growth may continue to outperform other major economies as the Fed keeps interest rates more elevated than peers. This tends to strengthen the dollar.
2. Geopolitical risks: Escalating tensions would increase demand for safe-haven currencies.
3. US presidential election: There’s a lot of uncertainty around future government policy. Our analysts believe the asset price responses this time around should be more modest than in both 2016 and 2020, regardless of the election outcome.