The US Dollar Index (DXY), which measures the value of the US Dollar (USD) against six major currencies, continues its gains for the third straight session and is trading around 98.60 during European hours on Friday. Traders will likely be watching the University of Michigan Consumer Confidence Index for December later today.
The US dollar’s upside may be limited amid rising expectations of interest rate cuts by the US Federal Reserve following an unexpected decline in the US Consumer Price Index (CPI) in November. The CME FedWatch tool shows a 73.3% probability of holding interest rates at the Fed’s January meeting, down from 75.6% the day before. Meanwhile, the probability of a 25 basis point rate cut rose to 26.6% from 24.4% a day earlier.
The US Bureau of Labor Statistics (BLS) released on Thursday that the US Consumer Price Index (CPI) fell to 2.7% in November. This reading was lower than market expectations of 3.1%. Meanwhile, the US core CPI, which excludes volatile food and energy prices, rose 2.6%, missing expectations of 3.0%. This number represents the slowest pace since 2021.
US President Donald Trump said on Thursday that the next head of the Federal Reserve will be someone who believes in cutting interest rates “significantly.” Trump also indicated that he will soon announce a successor to current Fed Chairman Jerome Powell.
Frequently asked questions about the US dollar
The US dollar (USD) is the official currency of the United States of America, and the “de facto” currency of a large number of other countries where it is traded alongside local banknotes. It is the world’s most traded currency, accounting for more than 88% of total global forex trading volume, or an average of $6.6 trillion in transactions per day, according to 2022 data. After World War II, the US dollar took the place of the British pound as the world’s reserve currency. For most of its history, the US dollar was backed by gold, until the Bretton Woods Agreement in 1971 when the gold standard disappeared.
The most important factor affecting the value of the US dollar is monetary policy, which is shaped by the Federal Reserve. The Fed has two missions: achieving price stability (controlling inflation) and promoting full employment. The basic tool for achieving these two goals is adjusting interest rates. When prices rise too quickly and inflation is above the Fed’s 2% target, the Fed will raise interest rates, which helps the value of the US dollar. When the inflation rate falls below 2% or when the unemployment rate is very high, the Fed may cut interest rates, which affects the dollar.
In extreme cases, the Fed could also print more dollars and activate quantitative easing (QE). Quantitative easing is the process by which the Federal Reserve dramatically increases the flow of credit into a stuck financial system. It is a non-standard policy measure used when credit dries up because banks will not lend to each other (due to fear of the counterparty defaulting). It is a last resort when simply lowering interest rates is unlikely to achieve the necessary result. It has been the Fed’s weapon of choice to combat the credit crunch that occurred during the Great Financial Crisis of 2008. This involves the Fed printing more dollars and using them to buy U.S. government bonds mostly from financial institutions. Quantitative easing usually leads to a weakening of the US dollar.
Quantitative tightening (QT) is the reverse process whereby the Fed stops purchasing bonds from financial institutions and does not reinvest capital from bonds it holds outstanding in new purchases. It is usually positive for the US dollar.
