Skip to content
Author
PUBLISHED: | UPDATED:

One of the many surprising aspects of financial market performance since the start of 2017 has been the weak performance of the dollar, which has fallen by close to 10 percent on a trade-weighted basis and by about 17 percent against the euro.

This has occurred despite a variety of factors that might have been expected to push the dollar up. These include upward revisions in economic forecasts, expectation of monetary tightening, rising real and nominal long-term interest rates, fiscal stimulus on a huge scale in a full-employment economy, rising protectionism that should choke off import flows and tax reform directed at reducing capital outflows and increasing capital inflows.

It is instructive to consider what the combination of interest rates and current exchange rates says about market expectations of future currency values. U.S. 10-year interest rates are about 220 basis points above German rates and about 280 basis points above Japanese rates. This implies that markets expect depreciation of the dollar by more than 25 percent against its major competitors over the next decade. If dollar depreciation of this magnitude were not expected, investors would prefer dollar assets to foreign assets, given the interest-rate differentials.

Some, but probably less than half, of the dollar’s weakness can be explained by higher-than-expected inflation in the United States. Real interest rates imply an expectation of continuing real depreciation.

Given the movements in interest rates over the past year, along with the dollar’s fall, it is reasonable to estimate that 10-year expectations of exchange rates of the dollar against the euro have fallen by perhaps 15 percent. Information on real yields suggests that much of this move reflects expected declines in real exchange rates.

Exchange rates are relative prices, and to understand dollar fluctuations one has to look at what has happened in the United States as well as in other countries. It is true that improvements in the U.S. economic outlook have been smaller than those in Europe and a number of other countries. To the extent that dollar weakness reflects disproportionate improvement abroad, it undercuts claims that U.S. policy is the reason for recent strong performance, given that Donald Trump is not president of the whole world.

But this is only a partial explanation. If it were the dominant story, one would expect to see rates in other countries rise more than in the United States as they experienced larger increases in demand for investment funds. This has not happened for the most part. For example, both U.S. real and nominal rates have risen relative to European rates. Put differently, expected future exchange rates have declined more than current rates. The dollar’s weakness has also been pervasive against Canada and Mexico, which have not had growth surprises.

The pattern of higher interest rates and a weakening currency suggests that on multiple dimensions, U.S. assets have to be put on sale at bargain prices to persuade foreigners to hold them or to induce Americans not to diversify into overseas assets. This pattern is relatively uncommon in the United States, though it happened during the Carter administration before Paul Volcker’s appointment as chair of the Federal Reserve and during the Clinton administration before Treasury Secretary Robert Rubin’s invocation of the “strong dollar” policy. It is fairly ubiquitous in emerging markets, where it reflects anxiety over a country’s policy framework.

I fear such anxiety may be emerging in the United States. President Donald Trump and Treasury Secretary Steven Mnuchin show their ambivalence about a strong currency. Washington consciously pushes budget deficits way up in a full-employment economy. Questions have arisen with respect to the Fed’s independence, the United States’ traditional receptivity to foreign investment and its willingness to lash out at holders of dollar assets.

These concerns are greatly magnified by the decision last week to impose across-the-board tariffs on steel and aluminum imports. The decision to invoke national security trade protections over the objection of the defense secretary raises questions about the coherence of policy processes. The fact that declines in the aggregate U.S. stock markets were about 100 times as much as the gains for steel and aluminum companies illustrates that because the steel-using sector dwarfs the steel-producing sector, the net effect of the tariff policy is to reduce U.S. competitiveness even before considering foreign retaliation. And then there is the risk that a president who likes trade wars will have more of them.

The confidence of global markets is much easier to maintain than to regain. Currency markets are sending a signal that the United States is not on a healthy path. Its time for the United States to strengthen the strong fundamentals on which a strong dollar and healthy economy depend.

Summers is a professor at and past president of Harvard University. He was treasury secretary from 1999 to 2001 and an economic adviser to President Barack Obama from 2009 through 2010.