Trump policies boost the dollar, thwart his trade goals

Trump policies boost the dollar, thwart his trade goals
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In its effort to reduce the U.S. trade deficit, the last thing that the Trump administration now needs is a strengthening U.S. dollar. Yet that is what is all too likely to happen over the next year largely as a result of the administration’s budget policies.

This will make any progress on reducing the U.S. trade deficit highly unlikely, since a strong dollar would weaken the U.S. competitive position in international markets.

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One reason for expecting that the U.S. dollar will strengthen in the year ahead is the likely increase in the divergence between U.S. monetary policy and that in Europe and Japan that will be caused by an expansive U.S. budget policy.

 

In the U.S., the Federal Reserve is all too likely to have to raise interest rates at a faster pace than it is now expecting to do in order to prevent an overheating economy from resulting in inflation.

This is particularly the case considering that the expansionary effect of the Trump tax cut and public spending increases will be occurring at the very time that the U.S. economy is at close to full employment.

While the Fed is likely to be raising interest rates more aggressively than at present, both the Bank of Japan and the European Central Bank are highly unlikely to do so.

Indeed, rather than raising interest rates, it is all too likely that they will continue with their ultra-unorthodox monetary policies of quantitative easing to support their economies. They will do so as inflation continues to fall well short of their targets and as their economies start to stutter.

A second reason for thinking that the dollar will continue to strengthen is because of the differential impact of the recent increase in international oil prices on the U.S. and the other industrialized countries.

Being a large oil producer itself, the U.S. can weather the recent sharp increase in international oil prices to $80 a barrel. The same cannot be said of the highly oil-dependent European and Japanese economies, which are not oil producers.

Yet another reason for expecting dollar strength in the period immediately ahead is the likelihood that the euro’s relative attractiveness will be considerably dented by the deterioration in Italy’s political economy.

The election of a populist government in Italy is bound to raise questions about that country’s ability to grow its way out from under its public debt mountain and its serous banking sector problems. Trouble in the eurozone’s third-largest economy is bound to cast a long shadow over the euro’s long-term prospects.

One consequence of the combination of a rising dollar and higher U.S. interest rates will be the repatriation of capital to the United States from the emerging market economies. This could very well complicate economic management in important emerging market countries like Argentina, Brazil, Indonesia, Mexico, the Philippines, Russia and Turkey, which all have already seen their currencies weaken considerably in recent weeks.

Yet another consequence of a rising dollar could very well be to heighten the risks of the spread of beggar-thy-neighbor trade policies around the globe.

One cannot exclude the chances that a widening in the U.S. trade deficit that would follow from dollar strength would induce the Trump administration to move toward an even more restrictive import policy than at present. That in turn could invite retaliation from the U.S. trade partners and lead us well down the path to a world trade war.

All of this heightens the urgency for a rethink of U.S. fiscal policy with a view to getting a better balance between fiscal policy and monetary policies so as to put less upward pressure on the dollar.

However, judging by the administration’s economic policy record to date, I would not recommending holding one’s breath for this to happen. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.