The last thing that the president needs is for a dollar decline to add more inflationary pressure.
Something troubling is happening to the dollar. Despite many reasons to think that the dollar should be appreciating, since the start of the year it has depreciated by around 10 percent. President Trump would be well advised to pay attention to the causes for the dollar’s decline before he proceeds with his budget-busting tax-cut proposal that could precipitate a real dollar crisis. With his import tariffs likely to exert upward pressure on prices, the last thing that Trump needs is for a dollar decline to add more inflationary pressure and for it to add to the government’s borrowing costs.
Among the reasons to think that the dollar should be appreciating is Trump’s aggressive trade policy. Normally when a country increases its import tariffs on another, we would expect that country’s currency to appreciate. It would do so to offset at least in part the gain in competitiveness achieved by the country imposing the tariffs. Put another way, if Americans spend fewer dollars on foreign goods that should, all things being equal, increase the value of the dollar as fewer of them are being exchanged for foreign currencies. Yet, despite Trump having increased import tariffs to their highest level in the past 100 years, the dollar has lost around 10 percent in value since the start of the year. The tariffs, which are still in flux and have been blunted (so far) by stocks of goods already in the U.S., are only starting to have an effect, but normally the markets would be anticipating their longer-term consequences. That the dollar is sinking instead suggests that the tariffs’ theoretical boost to the currency has been offset by declining confidence in the U.S. fiscal position.
We would also expect the dollar to appreciate when interest rates in the United States increase relative to those of our trade partners. The interest rate spread between us and our trade partners has widened: The Federal Reserve has been sticking to a tight monetary policy while the European Central Bank and the Bank of China have been cutting interest rates to stimulate their economies. However, despite the widening of the short-term interest rate advantage to 2 ¼ percent in favor of the United States with respect to the eurozone, the dollar has been declining.
An even more serious reason for concern is that the dollar has been declining even at a time when there has been increased stock-market turbulence and economic and geopolitical uncertainty both at home and abroad. Normally when such conditions prevail, international investors turn to the U.S. Treasury bond market and the dollar as safe havens. Yet, this has not been happening. The dollar is declining, and long-term Treasury bond yields have been increasing. That, together with the 33 percent surge in the gold price to around $3,400 an ounce since the start of the year, suggests that foreigners are beginning to lose confidence in American economic exceptionalism.
It might be recalled that foreign creditors own around one-third of the $29 trillion U.S. government bond market. They also finance a large part of our gaping trade and budget deficits. With investors already losing confidence in the United States, it is not a good idea to further undermine that confidence by raising fears of a serious U.S. government bond- and dollar-market crisis. Yet, that is what Trump’s policies will lead to.
As alluded to above, congressional passage of the One Big Beautiful Bill is not reassuring foreign investors. According to the nonpartisan Congressional Budget Office, it is estimated that if implemented, over the next decade that bill would add $2.4 trillion to a budget deficit that is already running at around 6.5 percent of GDP. In turn, that instills foreign-investor fear that the public debt would become unsustainable and that the U.S. might try to inflate its way out of its public debt problem. Further stoking the fear of future inflation is Trump’s frequent demands that Federal Reserve Chair Jerome Powell cut interest rates aggressively, even at a time when inflation is running above the Fed’s 2 percent inflation target. Powell’s current term as Fed chair ends in May next year, when a more dovish Fed chair might be appointed, a fact of which international investors are very well aware.
The other way that Trump is undermining confidence in the government bond and dollar markets is by raising the possibility that the United States might not fully honor its government-debt commitments. Foreign investors seem to be particularly alarmed at Section 899 of the One Big Beautiful Bill. According to that section, Trump would be able to impose a tax of up to 20 percent on the interest earnings of our foreign creditors in countries that are deemed to be pursuing tax policies unfair to U.S. interests.
Trump has frequently mentioned that he would like a cheaper dollar to help reduce the trade deficit. However, he should be careful about that for which he wishes. With the kind of policies that he is pursuing, he could invite a full-blown dollar crisis. If that were to happen, he risks stoking inflation, since each 10 percent dollar depreciation would have the same inflationary impact as a 10 percent import tariff hike. He also risks a further spike in long-term interest rates that would heighten the likelihood of an economic recession.