Dollar hegemony could spark a new crisis
With fears of stagnation in the US rising, especially after lower than expected job creation and consumption growth in April, the Federal Reserve has proposed a new monetary policy, reverting interest rates to zero and resorting to unlimited quantitative easing, as it had done when the 2008 global financial crisis broke out.
The huge liquidity released by the Fed has already impacted the global financial market, not only causing the depreciation of the US dollar and creating panic in the market, but also triggering a new exchange rate competition, which could lead to a new economic crisis.
Relative stability is one of the basic characteristics of the dollar as a leading international currency and also the basis of its hegemony. But the Fed’s aggressive interest rate cuts and unlimited quantitative easing policy have released huge amounts of dollars in the foreign exchange market, causing the dollar index to fall from a high of 102 in March 2020 to below 90 in January this year — a depreciation of more than 10 percent.
This has happened at a time when the European Union and Japan are yet to fully emerge out of the financial crisis and their interest rates have stayed at zero or slid into negative territory in recent years, reducing the room for further interest rate cuts. The latest round of zero interest rate policy has basically eliminated the interest rate gap between the US and other developed economies, thus further increasing the depreciation pressure on the dollar.
The huge liquidity the Fed has released in the market will also cause the gradual decline of the petrodollar. The termination of the agreement reached by the Organization of Petroleum Exporting Countries and other oil producing economies to cut oil output has sent oil prices tumbling, with the trend being further exacerbated by declining oil demands due to the novel coronavirus pandemic.
The spot price of Brent crude was about $70 per barrel at the start of 2020 but it collapsed to below $10 in April last year. And on April 20, 2020, the price of US crude oil futures WTI plummeted to a record low — in fact, it entered negative territory the first time in history. Low oil prices, aside from potentially crippling the US shale oil market, will also significantly reduce the demand for petrodollars in the world market.
The Fed’s radical monetary policy has not only failed to produce expected economic effects but also increased panic in the market in the short term. The futures of three major US stock indexes fell sharply after the Fed cut interest rates, triggering a circuit breaker, with the Dow Jones Industrial Average touching its daily limit and closing down nearly 3,000 points, the biggest single-day loss in history.
As such, investors now lack confidence in the future of the US economy. At such a time, the Fed’s move to lower interest rates to zero has further sullied the US’ image as an “unreliable and irresponsible” economy. And the Fed’s “fall-to-the-bottom” interest rate policy has significantly reduced the space for monetary policy adjustments in the future, further lowering market expectations on the dollar. These factors have, to some extent, shaken the market’s trust in the dollar as a stable international currency.
US President Joe Biden issued a series of executive orders within a week of taking office to intensify efforts to contain the pandemic and boost economic recovery, but the prospects appear dim. The massive vaccine rollout could have helped boost the US’ economic recovery, but there have been reports of widespread chaos in vaccine distribution and inoculation.
And the longer it takes to achieve herd immunity, the harder it will be for the US to realize economic recovery. Moreover, the Biden administration has rolled out an ambitious $1.9 trillion stimulus plan, but with the Democrats and Republicans at odds and US society deeply divided, the massive stimulus may not yield the desired results.
Given the greenback’s hegemony, a sharp interest rate cut will cause US dollars to flow into other financial markets in pursuit of higher returns, which will have a negative impact on other countries’ monetary policies. And in order to reduce their financial losses and ensure financial stability, there is a high probability that other countries, too, will turn to quantitative easing with interest rate cuts, which will result in a new round of exchange rate competitions, sparking competitive currency devaluations and posing a serious threat to the global economy.
Besides, the space for other countries to maneuver their monetary policies will become increasingly narrow and the marginal effect of stimulus policies will weaken. And if the pandemic is not effectively controlled in a short time, the world economy could be trapped in a “downward spiral”, and we could face a new global economic crisis.