Global Navigator from KPMG Economics

December 12, 2024

In a 1965 presidential address, Charles de Gaulle of France criticized the unique advantages that the US enjoys due to the special status of the US dollar. He was talking about what would become known as “exorbitant privilege.” That refers to the benefits that the United States economy reaps from the US dollar’s status as the international reserve currency. It allows the US to avoid the jump in interest rates typically linked to growing government deficits. That status extends to the Federal Reserve and means its decisions have spillover effects the world over.

On a recent trip to Asia, KPMG Senior Economist Ben Shoesmith sat down with executives from multinational firms. This edition of Global Navigator highlights what was heard on the ground: Concern about the US dollar’s “exorbitant privilege” and spillover effects of US monetary policy featured heavily in those conversations. Companies in Asia are seeking shelter from the potential spillover effects of the Fed’s monetary policy actions, including currency fluctuations. The latter is crucial as it could represent a warning shot over the bow for broader financial market stability. Currency swings are occurring, despite the otherwise welcome news regarding rate cuts by the Fed.

The Fed’s decisions, its impact on currencies and the actions of other central banks topped the discussions with Asian executives. There was some talk that countries most vulnerable to protectionist policies and sanctions could move away from using the dollar. Recent shifts in the geopolitical landscape since then, including a setback for Iran, could undermine efforts to move away from the dollar.

The reserve currency status of the dollar shelters the US from some of the worst repercussions of widening federal deficits by allowing for lower borrowing costs; investors flock to the US Treasury bond market in times of uncertainty. Over half of foreign transactions are denominated in dollars, which amplifies the role the Fed plays in the global economy. Movements in US bonds spur currency fluctuations.

Sharp currency depreciations lead to inflation, higher borrowing costs and capital flight; historically, they have triggered full-blown financial crises in emerging markets. That has prompted many central banks to move when the Fed does to minimize spillover, even at the expense of growth.

The Fed has already signaled it intends to slow the pace of rate cuts in 2025. Our forecast is now for three cuts by year-end 2025, one-half percent less than a month ago, and a full percent lower than we expected when the Fed started its rate-cutting cycle in September.

Executives were eager for additional rate cuts, as they would decrease the cost of borrowing in dollar-denominated debt. Hope was high that Fed rate cuts would open the door to the same action by their own central banks.

Rising US bond yields have strengthened the US dollar against major currencies since the election, posing challenges for our trading partners' stimulation efforts. The currencies of Mexico and Canada, our closest trading partners, have been hit particularly hard. That raises import costs and puts a floor under inflation, making it harder for their central banks to cut rates.

The same is true of the euro, as much of the eurozone remains extremely weak. The yen has depreciated but is still in a better position than it was earlier in the year when the Bank of Japan (BOJ) began rate hikes. The Chinese renminbi has depreciated by nearly 15% in the last few years. Further depreciation would make goods more expensive, possibly counteracting what looks like borderline deflation in China. The problem is how those shifts would be interpreted by trading partners; they could inflame trade tensions and trigger more protectionist policies.

The Fed’s upcoming framework review in 2025 came as a surprise to executives in Asia. The review could change how the Federal Open Market Committee (FOMC), the policy decision-making arm of the Fed, interprets its dual mandate of maximum employment and price stability. That could have implications for the Fed’s responsiveness to different shocks and could change the terminal rate. The longer-run fed funds rate has already drifted up in the Fed’s own forecasts.

What is perhaps more important than de-dollarization is the chaos that could ensue in currency markets should the dollar destabilize. Treasury bond yields have moved higher in response to fears of higher inflation and ballooning government deficits. That has triggered spillover effects, including a stronger US dollar and destabilizing currency depreciations abroad.

The largest risk to dollar stability today would be a catastrophic internal US policy mistake (or several at once) that sinks confidence. Risks include erosion of the Fed’s independence, a full-scale trade war, growing deficits and uncertainty surrounding government shutdowns and debt ceiling negotiations. Most of the downgrades to the debt ratings since the 2011 debt ceiling crisis were due to an “erosion of governance” or political brinkmanship instead of the surge in debt loads.

The president-elect has said the Fed should consider input from him when making decisions on interest rates. Historically, political interference in central banking has resulted in stagflation similar to what the US experienced in the 1970s.

The prospective members of the president-elect’s cabinet have said that they would like to pursue dollar depreciation to combat the trade deficit, akin to the Plaza Accord of 1985. That could contribute to financial instability which would erode dollar dominance. We assume an intentional depreciation of the dollar would not be successful given the level of coordination required with other central banks. If faced with tariffs from the US, other countries may want to keep their currencies weaker to offset the costs for their buyers. Depreciation, whether organic or via currency intervention, makes exports cheaper. That could blunt the blow of tariffs in a full-scale trade war scenario.