The State of the Dollar: US Monetary Policy in a Shifting Economic Climate

This article examines the rising pressures on the US dollar, shifting investor behaviour, the rise of potential alternate currencies, and the implications of a weaker dollar. This article was written by Harold Law and edited by Aranyika Kapur.

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Investors' love for American stocks is stronger than ever. However, their confidence in the US currency increasingly appears to be a different story. The year 2025 has proven particularly challenging for the greenback (USD), which has already registered an 11% depreciation against the euro, with Goldman Sachs’ chief economist forecasting a further potential depreciation of 25-30% over the next few years. The dollar has faced pressure before, such as the “Nixon shock” when America abandoned the gold standard in 1971. However, recent market and scholarly speculation suggests that this time may be different. Could the dollar’s status as the world reserve currency truly be under threat?

Why Dollar Dominance Matters

If the pessimists are right, the consequences would be enormous. Since its confirmation as the world reserve currency at the 1944 Bretton Woods Conference, the dollar has acted as the main lubricant for global trade and finance, enabling conversion, borrowing and hedging on a massive scale. It has also served as a safe haven asset, giving investors somewhere to flee in times of peril, and central banks a stable currency to hold in their foreign exchange reserves.

It has also confirmed what former French President Valéry Giscard d’Estaing, famously called an “exorbitant privilege” on the United States, offering significant geopolitical and economic advantages. For instance, the United States can shut off access to dollar-based trading for nations that incur its displeasure, isolating them from a large proportion of global trade, as it did in response to Russia’s invasion of Ukraine. This has also allowed America to run up huge national debts, as investors remained confident that its Treasury bonds will continue to attract buyers because they pay out in dollars which are always in demand for international transactions. It is clear that even a weakening in the greenback’s cachet, let alone something more serious, could have profound economic and geopolitical impacts internationally.

What’s Pushing the Dollar Down

Several events in recent months have sapped investor confidence, most obviously the announcement of President Trump’s “Liberation Day” tariffs in April. In the ensuing economic uproar, rather than buying dollars as usual in a crisis, investors sold them off. This indicates that the greenback is no longer the safe haven asset it once was, due to the perception of US economic policy as less rational and predictable than it used to be.

Another worrying sign is the decoupling of the dollar’s price from yields on US Treasury bonds, which it reliably tracked for decades. When a nation’s bond yield declines, the value of its currency falling is unsurprising, as investors prefer to buy currency that they can lend to other governments willing to pay higher interest. However, when bond yields rise while the currency depreciates, as has happened in the US recently, it potentially signals that the dollar is seen as fundamentally risky.

This has set off a dangerous feedback loop as investors increasingly hedge investments against shifts in the dollar in light of the unpredictability of President Trump’s actions. Deutsche Bank’s George Saravelos has found that almost 80% of inflows into US stocks are now hedged, up from essentially zero in the past. This erodes the differences between riskier currencies and the dollar, previously seen as safe from dollar exposure as a result of investing in American stocks. Additionally, hedging itself often involves selling dollars, adding further pressure on the greenback.

Investors have also been unsettled by the Trump administration’s attempts to strong-arm the Federal Reserve. Jerome Powell, the Fed’s chairman, has been reluctant to cut rates at the pace President Trump desires, fearing inflation risks tied to recent tariff policy. This has provoked a characteristically strong reaction, with Trump repeatedly threatening to remove Powell. While unsuccessful, he has continued to attempt to influence the institution in other ways, appointing loyalist Stephen Miran to the Federal Reserve Board of Governors and attempting to fire board member Lisa Cook for alleged mortgage fraud, presumably to make room for his preferred appointees. Moreover, Miran’s belief that the Fed should cut rates by 1.25% by year-end provides an unsettling preview at how a Trump-dominated Federal Reserve might behave: rampant inflation would be likely, reducing returns on dollar assets, and exacerbating pressure on the currency.

Lessons From Past Panics

The dollar is in a tight spot, but does this actually translate to a credible threat to its status as the world's reserve currency?

Historical concerns about the dollar may offer some insight. The economic malaise of the late 1970s, the economic crash of 1987, the great bond massacre of 1994 and the financial crisis of 2008 are all prime examples of threats the dollar has faced before. In each case, it has weathered pressure and even strengthened its dominance, due to a combination of long-term confidence that the US would continue leading the world economy, and the lack of a real contender currency.

The first statement continues to hold true today. Despite the possibility of economic troubles for the United States in the near future, the nation’s real advantages mean it will almost certainly continue to be an economic superpower in at least the first half of the 21st century. However, it also seems increasingly plausible that the dollar’s world reserve status will gradually weaken and may eventually disappear. This isn’t likely to involve replacement by another single currency, but rather through a gradual diversification by central banks, investors and companies into holding reserves and conducting transactions in renminbi and euros, as well as dollars.

Factoring in China and the EU

As far back as 2009, the then Governor of the Peoples Bank of China, Zhou Xiaochuan, argued that over-reliance on the dollar was dangerous for the world economy and diversification was needed. China is now taking concrete action, extending yuan loans to central banks, and introducing the new CIPS system as a challenge to the American SWIFT system for bank-messaging. Countries outside the West, like Hungary, and American opponents, like Russia, are increasingly issuing yuan-denominated bonds to Chinese investors. However, China seems to harbour no illusions about taking over the role of the dollar as its heavily state-controlled trading and financial systems stand in the way. Nevertheless, it is certainly making progress in eroding the all-pervading power of the dollar in international trade.

Similarly, EU leaders are working to increase the euro’s global role. Christine Lagarde, the ECB president, has written about the “tangible benefits” of “increasing the euro’s global status.” The euro already makes up 20% of international central bank reserves, and that figure has been increasing since the financial crisis. The euro, like the renminbi, is not placed to take over the role of reserve currency, mostly due to Europe’s stagnant growth and perceived declining economic and geopolitical influence. But the euro’s gains against the dollar this year suggest investors may be warming to it as the dollar starts to look riskier.

Finally, investors and central banks seem progressively more inclined towards using gold as a truly safe haven in response to the absence of currencies fulfilling that function. Central banks added 19 tonnes of gold to their reserves in August according to the World Gold Council, and its prices have surged on international markets.

Conclusion

Ultimately, while the dollar is not likely to be replaced, its dominance as both a lubricant of international trade and as a safe store of value is being eroded. This likely means serious headaches for US policymakers in the next few years. For one, it will mean adversaries are increasingly resistant to being shut off from the dollar trading system, as they will be able to make use of other currencies like the Chinese yuan for conducting trade and issuing bonds.

Furthermore, not only is the United States losing interest in playing world ‘Globocop’, it is losing valuable tools which once allowed it to perform this function. Even more worryingly are the implications for its national debt. America has grown addicted to borrowing in recent years, running a deficit of 6.4% in 2024, extremely high for a year without an economic crisis, while its debt-to-GDP ratio now exceeds 120%. The pre-eminence of the dollar has allowed the US to borrow on this scale without yields rising too much, but as investor appetite for American debt wanes, the United States will be faced with some hard decisions.

America is not experiencing absolute decline and is still well placed to exercise power in the 21st century. But in the context of America’s polarised politics, and the unhealthy state of its finances, observers are right to worry about the consequences of the US losing its “exorbitant privilege.”