“Should today’s Fed eradicate inflation as effectively as the Volcker Fed did over 40 years ago, the dollar may find itself as dominant.

The greenback’s rise against other currencies since the conflict in Ukraine broke would seem to bear out this argument. But is this true?

The argument that the dollar should lose international stature, and value, as a result of the conflict largely rests on the notion that other regimes around the world, or even private firms and individuals will be scared off from holding or using the dollar for fear that the US can “weaponise” the dollar as it has done with Russia – and Iran before that.

However, we can’t think that there’s many regimes out there that are thinking of invading their near neighbour and hence that there are many private firms/individuals that think they might be sanctioned in the same way that we’ve seen in Russia. So, these concerns seem overblown. But does this mean that dollar hegemony will just get stronger and the dollar rise in value as it does?

In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, not necessarily. For there are two things going on here: weaponization of the dollar and inflation. And it is the latter that threatens to unseat the dollar, not the former. This is because the current monetary system that’s based on US and dollar leadership is inherently inflationary. There are no checks on the ability of the US, through the Fed, to expand dollar liquidity dramatically.

That’s something we’ve seen not just since the Ukraine conflict, and not just since Covid; but something that goes back to the global financial crisis when the Fed’s balance sheet was around a tenth of what it is now. This has fed rampant inflation; firstly, in asset prices and more latterly in goods and services prices as the supply of these became as inelastic as the supply of financial assets had been.

Hence the question for dollar users now is not whether they will be sanctioned, but whether the current monetary system is inherently inflationary and needs to be replaced by one where other currencies from Europe’s ‘museum’ or China’s ‘jail’ effectively compete with the Fed and the dollar on the basis of monetary prudence to gain market share from the greenback.

In other words, should the world move from dollar dominance to a multipolar currency system in which there’s stronger currency competition and hence much less global liquidity creation? “If users of dollars believe that the answer to this is ‘yes’ and ditch the dollar in favour of other currencies, the greenback could slip back, just as the pound did when it lost its globally dominant role after the two world wars”, Mr. Steve Barrow said.

In considering this question, there could be something of a precedent in the 1970s. That marked the last bout of globally rampant inflation. Then, like now, much of the blame was put on commodity prices – specifically energy. But this was not the only factor in Mr. Steve Barrow’s view as the inflation back then came after Bretton Woods broke down, the dollar was deanchored from gold and US monetary growth soared. It was also a time that the dollar fell in value and was only rescued in the early 1980s after the Volcker-led Fed took interest rates up dramatically.

In short, the experience of the mid-late 1970s could prove a template for what is about to happen, and not just in terms of the stagflation threat that is so widely talked about. Of course, the period since the 1970s has not seen dollar usage fall despite the high inflation; quite the reverse. But, as mentioned, that may have been down to the fact that the Volcker Fed came down so hard on inflation with real policy rates rising to 8% compared to the current real rate of near -8%.

“Should today’s Fed eradicate inflation as effectively as the Volcker Fed did over 40 years ago, the dollar may find itself as dominant, if not more dominant, than before inflation surged. But if not – and this has to be the risk – the dollar’s demise could still occur even if it is not sanction fears that spark the decline”, Mr. Steve Barrow said.