4. The Fed, the ECB and the Bank of Japan: why the dollar rules the rest
Macro 2: Central banks
The three big central banks of the developed world use similar tools and pursue similar objectives, and yet they are not playing the same game. One of them sets financial conditions for everybody else without meaning to, and the other two react. Grasping that hierarchy changes entirely how you read a calendar of meetings.
Three mandates, three different constraints
- The Federal Reserve answers to a relatively closed economy: foreign trade is a small share of its GDP, so it can afford to ignore the exchange rate in its decisions. And it issues the currency the rest of the world uses.
- The European Central Bank applies a single policy to a group of countries with different debts, banks and cycles, without a common Treasury issuing a safe asset for the whole area. Its constraint is not only inflation, it is fragmentation, meaning that its decision reaches Germany and Italy so unevenly that it stops being a single policy.
- The Bank of Japan comes from three decades fighting the opposite problem, deflation, with an enormous public debt relative to its economy. For it, raising rates is not merely a matter of cooling demand: it abruptly raises the cost of servicing that debt and hits the bond portfolio of its entire financial system.
When a central bank strikes you as incoherent, look for its constraint first. It is almost never the one in the headline.
Why the dollar is not just another currency
The asymmetry comes not from the size of the American economy but from the functions the dollar accumulates beyond its borders:
- It sits on one side of the vast majority of foreign exchange transactions, something like nine out of every ten.
- It is close to 60% of the world's central bank reserves, far above the United States' weight in global GDP.
- It is used to invoice roughly half of international trade, including transactions where neither party is American.
- Companies, banks and governments outside the United States have borrowed in dollars on a scale counted in trillions. That system of dollars created outside the country, the so-called eurodollar, is nobody's to control entirely.
That last point is the decisive one. A Turkish, Brazilian or Korean borrower who owes dollars earns income in their own currency and holds an obligation in somebody else's. When the dollar appreciates, their debt grows in their own currency without them having borrowed a further penny.
The Fed sets the world's monetary policy whether it wants to or not
From this comes the central mechanism of this module. When the Fed tightens:
- The dollar tends to appreciate, because the risk-free dollar asset becomes more rewarding.
- The dollar debt of foreign borrowers becomes more expensive in real terms, and international banks cut their exposure.
- Global dollar credit contracts, and with it activity in countries that have taken no monetary policy decision at all.
The theoretical consequence is harsh: the classic textbook says a country with a floating exchange rate can run an independent monetary policy. The research of the past decade argues that, with a global financial cycle driven from the dollar, that independence is far smaller than assumed. Floating cushions, it does not insulate.
There is an escape valve: swap lines. The Fed lends dollars to other central banks, which in turn lend them to their local banks. In March 2020 those lines were extended to more than a dozen central banks and mobilized hundreds of billions of dollars. This was the Fed acting as lender of last resort to a dollar system that lives mostly outside the United States, with an obvious political implication: whoever is on the list gets protection, and whoever is not, does not.
Real case: the yen and yield curve control in 2022
In 2022 the Fed raised its policy rate by some 425 basis points. The Bank of Japan did the opposite: it kept its short rate negative and maintained its yield curve control, a regime adopted in 2016 under which it pegged the ten-year bond at around 0% within a narrow band, committing to buy whatever it took to defend it.
That regime has a consequence that has to be seen clearly: if you fix the price of the bond, you give up control of the quantity. When the whole world was selling Japanese debt because dollar yields were vastly higher, the Bank of Japan had to buy enormous volumes to hold the ceiling, expanding its balance sheet exactly when everyone else was shrinking theirs.
The adjustment had to come out somewhere, and it came out through the exchange rate. The yen went from about 115 to the dollar at the start of 2022 to above 150 by October, a depreciation of close to 30% in under a year. Japan's Ministry of Finance intervened by selling reserves for the first time since 1998. In December 2022 the Bank of Japan widened the band on the ten-year bond, widened it again in 2023, and in March 2024 abandoned yield curve control and ended negative rates.
The lesson closes the level: no central bank can fix the price of money, the quantity of bonds and the exchange rate all at once. Insist on two and the third will move. And when the Fed tightens, the currency is what pays for that insistence.