TalkingEconomics: Has the dollar turned?

In a break from tradition, Donald Trump has started to call for a weaker dollar, reversing the convention that the president always supports a strong currency.

Although the president’s ability to influence the dollar is limited, there is a case to be made for a reversal of dollar strength. Since the currency’s sharp appreciation, the trade sector has weighed on economic growth.

Outlook: weaker dollar potentially on the cards

The US dollar has been buoyed by the tightening of US monetary policy at a time when central banks elsewhere are keeping policy loose. However, the relationship between rates and currencies is not straightforward. Currencies tend to move ahead of interest rates as investors adjust their expected returns.

When interest rates move against a currency its value must fall to the point where it offers sufficient potential for appreciation so as to restore equilibrium. This is the basis for “overshooting” where a currency will move significantly ahead of rate changes, but will subsequently stabilise or appreciate when those moves materialise.

This ties in with previous tightening cycles by the Federal Reserve (Fed) where, instead of seeing the dollar rise alongside higher US interest rates, the picture is more mixed. Our analysis of eight previous cycles shows that on average the dollar tends to be slightly weaker to flat after the Fed starts to raise rates.

Something similar appears to be happening today: the dollar rose sharply ahead of the Fed beginning to tighten monetary policy but is now falling back, having overshot its long-run value.

Forecasting currencies is notoriously difficult, but it could well be that the president will get his wish and we now see a weaker rather than stronger dollar going forward as the overshoot unwinds.

Some implications

The end of dollar strength would remove a deflationary factor for the US economy. Import prices would rise more rapidly, adding to inflation.

However, it could add to deflationary forces in Europe and Japan, creating potential problems for the ECB and BoJ. Investors in these countries would also need to be wary of moves in the euro and Japanese yen if there were a significant move in the dollar, given the negative correlation these currencies have with their respective equity markets.

For the emerging markets, an end to dollar strength would come as a relief, easing concerns about the effects of tighter monetary conditions in the US being transmitted to emerging economies via dollar borrowing.