February 2025
This article appeared in the Business Post on 23rd February 2025
While tariffs have so far been the main focus of the new US administration, its policy on the US dollar could have even greater ramifications for global capital markets.
Historically, the US dollar policy has been one of benign neglect. However, with President Trump nostalgic for the glory days of American manufacturing and aiming to balance trade, the idea of actively weakening the dollar has emerged as a potential policy.
The issue for the US is that manipulating exchange rates to your advantage can be fiendishly difficult – it can be a case of careful what you wish for.
The dollar presents a trilemma for the administration:
On one hand, a weaker dollar might boost manufacturing. At the same time, Trump does not want to undermine the dollar’s reserve status. Meanwhile, arguably the most pressing issue is maintaining a stable dollar to attract foreign buyers of U.S. Treasuries to fund the large fiscal deficit.
Can they thread the needle?
Since the Bretton Woods Agreement of 1944 established the post-war international monetary system, the dollar’s status as the world’s reserve currency has been unchallenged.
Trade—even between non-US counterparties—is disproportionately invoiced in dollars and deep, liquid capital markets make the dollar the preferred choice for debt issuance. Unsurprisingly, central banks around the world hold about 60% of their reserves in dollars.
This position has allowed the US to borrow freely in its own currency, a phenomenon known as its exorbitant privilege. While this has long frustrated policymakers in Europe, China and other BRIC nations, no credible alternative to the dollar has emerged.
However, despite its reserve status the dollar has gone through cyclical ups and downs.
High inflation and persistent deficits in the 1970s, forced Nixon to abandon fixed exchange rates and the dollar tumbled. In the late 1980s the rise of Japan as an industrial powerhouse saw the dollar fall sharply versus the yen. Again in the early 2000s optimism around China and Europe saw the dollar fall sharply.
More recently, cyclical factors such as higher interest rates and a booming stock markets have been boosting the dollar. At the same time, a shift towards nearshoring amid deglobalization, has seen rising direct investment in manufacturing capacity in the US.
While arguably the stronger dollar has served the US well in attracting capital the perception is now that the dollar is overvalued. Anybody who has bought a coffee, beer or burger in New York recently will attest to that.
The Risks of Intervention
After a similar rise in the 1980s the US famously forged an agreement at the New York plaza hotel with its G7 partners to bring down the value of the dollar. Some strategists have argued in favour of a similar arrangement now.
However, notwithstanding the obvious challenge of striking a deal given more fraught international relations, meddling with the dollar could prove counter productive.
For one while it is reasonable to infer the dollar is overvalued the fundamental reason for the US trade deficit its relatively low savings rate – a lower dollar will only help trade at the margin.
A weaker dollar would drive up import prices, adding to inflationary pressures at a time when inflation is above target and tariffs already pose an upside risk. It could also make U.S. Treasuries less appealing, potentially raising borrowing costs.
At the same time, it’s possible cyclical forces might turn negative for the dollar which could accentuate the adverse impact of any misinformed action. Bear in mind, the dollar was also strong during a similar period of US exceptionalism, in the dotcom boom of the 1990s, but fell by about 40% once the tech bubble burst.
The Elephant in the Room
Because the US has run current account deficits for years those deficits have had to be balanced by portfolios flows into the US. Consequently, foreigners have accumulated about $60 trillion of US assets. If at some point sentiment turned and foreign investors started to sell US assets, you could get a disorderly decline in the dollar.
Of course economists have warned of such a risk for years and it has never emerged. When Russia’s foreign assets were frozen after the invasion of Ukraine there were again fears it may spur de-dollarization. The strong rally in gold in the last two years may be evidence of the beginning of a shift.
For now, with the economy solid and speculation of the Fed keeping rates on hold this year, the dollar continues to be supported. But markets are complex non-linear systems and sometimes it just requires a tipping point to start cascade of selling.
Treasury Secretary Bessent, who made his name betting on the dollar, surely understands better than most that the FX market is larger than any single player. The question is not whether the dollar’s dominance will wane, but whether the administration can navigate the shifting tides without causing unintended consequences.
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