How to manage the dollar (Part III)

Policy options to weaken the dollar

We previously noted Trump’s renewed interest in the dollar (Part I) and looked at various measures of dollar strength (Part II.) With the election now only days away, and the possibility of a Trump 2.0 administration from next year, the prospect of a “formal” dollar policy is now tantalisingly close.

Should a new Trump administration take seriously weakening the dollar, what policy options are available?

Options to weaken the dollar

The policy options for impacting the dollar fall into four categories, though there is overlap between these.

• First, acting on the current account (e.g., policies to impact imports and exports).

• Second, acting on the financial account (a Tobin tax, restrictions on financial inflows, or accumulation of foreign assets, for example.)

• Third, monetary policy (a dovish Fed and/or higher inflation target).

• Fourth, coordinated global policies to impact saving-investment balances along side exchange rates (e.g., fiscal consolidation to lower domestic saving alongside real exchange adjustment). 

It’s worth bearing in mind the driver of the US current account is the saving-investment balance of the economy as a whole—or low saving rate including due to loose fiscal policy. As such, any policy can only impact the external imbalance if it leads to a change in aggregate saving-investment decisions for the US economy as a whole or that of trading partners. This theme will recur.

I. Current account

One way to impact the dollar is to act on current account items, mainly the trade and service balance. The chart below shows the net balance due to goods, services, primary and secondary income. Goods and secondary income are debit items, while the US runs a surplus on services and primary income.

Briefly, options include:

• Goods balance: imports. Lowering imports through tariffs intended to reduce demand for foreign traded goods while improving the competitiveness of domestic producers who may be able to fill the demand. Crucially, such a tariff is like a tax on US consumers, contributing to government revenues while reducing real incomes—this lowers domestic demand while increasing saving, thus current account adjustment. Foreign economies may try to lower their nominal exchange rate against USD to raise domestic currency incomes of exporters to offset some loss of export volumes, so having second or third round effects globally. 
  

• Goods balance: exports. Alternatively, boosting exports through subsidies to domestic producers to lower the price to foreigners of US output. This will contribute to higher fiscal deficit in the US which may be offset by higher private saving. So the impact on the current account is ambiguous. Alternatively, de-regulation of closed sectors (such as in energy) opens up competitive US markets to foreign consumers with less fiscal impact–raising domestic incomes and saving.

• Service balance: Though net services run a surplus, efforts to improve net tourism or financial services through tax incentives is possible.

• Primary income balance: a tax on foreign investment income (Treasury coupons) would generate fiscal revenue and contribute to a lowering external balance assuming no retaliation on US investment income abroad.

Such analysis is inevitably partial equilibrium as, to work out the ultimate impact on the current account and therefore currency of such actions, it is necessary to work through the final impact on incomes and expenditures of US residents as well as foreigners. For example, a tariff on imports will initially lower US real incomes. But this could trigger wage claims to offset lost income, require tighter monetary policy as a result, driving a stronger dollar alongside restored real incomes.

II. Financial account

A alternative is to impact financial account transactions to lower foreign demand for dollars or raise demand for foreign currency.

• Reduce financial account inflows. This could be achieved through a tax on financial inflows (a Tobin tax) or restrictions on holding US assets (such as real estate) or the threat of asset confiscation (reducing US attractiveness as a safe haven.)

• Increasing outflows. Alternatively, residents could be encouraged to accumulate foreign assets, as with GPIF in Japan (though this is harder to achieve in the US context) or by encouraging less FX hedging. 

• Official intervention. A more aggressive policy would be an explicit decision to build US reserves. In a recent client call, Brad Setser explained three ways this could be achieved by the US government:

  • First, through the sale of non-fx assets (gold and SDR) in the Exchange Stabilization Fund (ESF), the proceeds then being used to buy foreign exchange. Setser noted that gold sales may be politically toxic. SDRs could be swapped at the Fed for USD then sold for FX. The problem with this is that SDR holdings are small, at about USD150bn, so would quickly run out of firepower.

  • Second, ESF could issue bonds to build up fx, borrowing dollars to sell for other currencies, a self-sterilizing policy. The problem with this is that the debt issued would count against the debt limit, so could be stymied by Congress.

  • Third, the Treasury could decide to accumulate FX deposits to reflect the large US external (including Treasury) debt. The Treasury is only constrained by the debt limit; within this limit, the Treasury has a large amount of discretion. They could expand the Treasury General Account (TGA) to hold a portion in FX at the Fed or could ask ESF to manage this portfolio.

The above measures would be a huge shift in US balance sheet management.

Each is sterilised as it does not involve the creation of base money liabilities as part of the FX accumulation. That said, as Setser noted, the Fed has unlimited authority to buy and sell as open market operation but has not historically done so. The Fed could choose to reinforce the Treasury’s FX policy, thus creating dollars.

It should be noted that FX purchases could in theory also be “outsourced” if the US can persuade other central banks to sell USD / buy their own FX (such as what the MoF/BoJ has been doing in 2022 and 2024). This makes most sense in cases where currency weakness has become a domestic policy concern, in which case the US could give the go ahead to intervention.

Accumulation against whom?

Imagine intervention were to happen.

It is worth pondering against which currencies purchases are likely. The obvious candidates for FX accumulation are friendly and developed market trading partners: JPY, GBP, EUR, SEK, NOK, KRW and TWD.

Many of these have large domestic central bank balance sheet holdings of govvies already through QE, so US purchases would have to be calibrated to the free float and risk profile and perhaps offset ongoing QT. 

But would the US wish to be exposed to the risk associated with, say, holding CNY assets? Wouldn’t this create a a conflict in the event of a further deterioration in relations?  

So the problem emerges that the US can probably only meaningfully shift the broad dollar index by acting on the bilateral nominal rates of a small subset of advanced trading partners and select emerging markets. But this would then make these economies less competitive against China, if CNY were less malleable, so shifting the problem elsewhere.

III. Monetary policy (interest rate policy)

An alternative approach would be to pack the Fed with dovish FOMC members, and a dovish Fed chair, with a tolerance for higher inflation—possibly by formalising a higher inflation target, so justifying a more rapid cutting cycle.

This would contribute to a more dollar depreciation and steeper yield curve.

The obvious concern with this is the erosion of central bank independence—and whether a higher risk premium is needed on long term debt issuance, risk premium for foreign investors.

Additionally, inflation is not popular—especially not after the recent post-pandemic spike. So this would likely be politically risky move.

IV. S-I balances and coordinated exchange rate adjustment

A final approach draws more heavily on the experience in the mid-1980s, when there was a set of coordinated policies by different jurisdictions.

The set-up is similar to today in that there is a wide fiscal deficit (so low US saving) with the potential for trading partners to acknowledge the need for nominal exchange rate adjustment under pressure of tariffs. 

Such coordinated policy includes a fiscal consolidation by the US (raising domestic saving) associated with a managed appreciation of the currencies of trading partners. Today, this could include measures by China to improve transfers to households and support domestic demand.

Unlike the above, this approach has the benefit of being general equilibrium and simultaneously working on spending and income decisions in the US and trading partners, intended to switch spending patterns while sustaining overall demand. 

Conclusions

It is not easy to manage the dollar.

The options facing the next US administration should they wish to do so range from acting on the current account (through tariffs, for example) or financial account (through a tax on foreign inflows or prohibition of foreign asset holdings). A more extreme solution would be unilateral reserve accumulation by the US. This may be more powerful, but the debt limit is an important constraint, so Congressional approval (implicit at least) would be needed. And reserve accumulation would require deciding which trading partners to accumulate against, which itself could distort their exchange rate against China—passing the dollar problem elsewhere.

Perhaps the best solution would be a combined fiscal consolidation in the US with real exchange rate adjustment agreed with trading partners. This requires a shared understanding of the problem. And it would require the next government to make fiscal adjustment a policy goal. Neither of these pre-conditions is in place at this stage.

The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective. The opinions and analytics expressed in this piece are those of the author alone and may not be those of Exante Data Inc. or Exante Advisors LLC. The content of this piece and the opinions expressed herein are independent of any work Exante Data Inc. or Exante Advisors LLC does and communicates to its clients.

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