Speculation is high that currency issues will be discussed at the Group of Eight leaders' meeting in L'Aquila this week. China has called for reform of the global reserve system and creation of a new international reserve currency based on special drawing rights (SDRs). Although the Chinese deputy foreign minister suggested on Sunday that China expected the dollar to be the world's main reserve currency for “many years to come”, action speaks louder than words: China said this month that companies taking part in a trial that uses the renminbi to settle trade will be eligible for export tax rebates.
It was only a question of time before the desirability of the dollar as the dominant global reserve currency would be questioned. Over the past decade, the US has failed to fulfill its basic obligation as the issuer of the global reserve currency: maintaining the dollar's value. After peaking in 2002, the dollar in trade-weighted terms has depreciated almost ever since. Although the financial crisis has given the dollar a lift owing to its haven status, the consensus is that this rebound will be short-lived. The US's aggressive policy response to the crisis – an extraordinary loosening of fiscal policy and large-scale asset purchases by the Federal Reserve – is raising serious concerns about the US's long-term inflation outlook.
Its recent record on inflation has not been reassuring. Consumer price inflation averaged 2.7 per cent, versus 2.1 per cent in the eurozone and 1.8 per cent in the UK, over the past decade. This disparity may stem from differences in institutional frameworks. The past 20 years have witnessed the adoption of inflation targeting by central banks of most developed and many developing economies. In contrast, US monetary policy is guided by the Fed's dual mandate of price stability and full employment. Whether the greater policy flexibility at the disposal of the Fed is in the best interest of the US is still unproven, but it is easy to see why it does not bolster confidence in the dollar, especially at a time when some of the structural disinflationary forces of the past decade may be in retreat.