The Fed needs to tread carefully with this strange dollar

Japan Times

2 days ago

The U.S. economy hasn't seen tariffs like these in around 80 years. Given the lack of recent precedent, the Federal Reserve is right to wait on more evidence that consumer prices aren't spiking before proceeding with interest rate cuts. There's another reason to tread carefully in these uncertain times: The extremely unusual behavior of the U.S. dollar.
Many economists — including Council of Economic Advisers Chair Stephen Miran — expected the buck to strengthen when U.S. President Donald Trump implemented tariffs. In an essay published last November, Miran wrote that the exchange rate was "more likely than not' to appreciate alongside an improving trade balance, as it did during Trump's first trade war in 2018 and 2019. The so-called currency offset was critical to his view that the new duties wouldn't necessarily be passed through to consumers, at least not entirely. Treasury Secretary Scott Bessent made the same point during his confirmation hearings.
Bafflingly, the dollar actually weakened for reasons that are still hotly debated (more on that shortly.) The U.S. dollar Index has declined by 6.8% since just before the "Liberation Day' tariffs unveiled on April 2 and it's down about 10% in 2025, the worst year-to-date performance in at least a quarter century. The median forecaster surveyed by Bloomberg expects the greenback to depreciate further over the next year or so.
All else equal, you might expect the upward pressure on U.S. consumer prices to be even worse than tariffs alone would suggest. In the past, for a given move in developed nation currencies, economists have identified long-run pass-through into import prices on the order of 60%. (Estimates were around 40% for the U.S. specifically.) But pass-through is highly context-dependent and all else is never equal. So far, measures of consumer inflation remain relatively tame, either because the transmission will take time to materialize; retailers are "eating' the higher costs in the form of narrower margins; or because the doomsayers were just plain wrong. Realistically, it could even be some combination of the three.
Given that range of possibilities, it's prudent to wait for the data to tell the story, exactly as Fed Chair Jerome Powell is currently planning. This is much to the chagrin of Trump, who regrettably insists that he can have tariffs and expeditiously lower policy rates too. In an ill-advised effort to get his way, he's exerting extraordinary public pressure on the independent central bank and its outgoing chair.
So why is the dollar weakening in the first place?
In the heat of the April selloff, many of us interpreted it as a sign of cracks in America's "exorbitant privilege.' The idea was that the U.S. — with the world's deepest and most liquid markets — had long occupied a special place at the center of the global financial system. That special status meant that we probably had a slightly stronger currency and relatively lower borrowing costs than would otherwise have been the case. When the the dollar weakened alongside rising borrowing costs after April 2, an argument advanced in market commentary and academia was that haphazard policymaking was eroding the American brand in the eyes of the world.
Another somewhat related argument was tied to capital flows. At the time of the tariff announcement, investors around the world were extremely exposed to U.S. equities, thanks in part to the remarkable outperformance of the U.S.'s mega-cap growth stocks, known as the Magnificent 7. From the start of 2020 until March 2025, the S&P 500 Index had outperformed the rest of the developed world's equity markets by more than two-to-one. Global investors had piled into the stocks to get a piece of the action, often through unhedged positions. The hasty unwind of some holdings briefly created a macroeconomically significant wave of outflows.
Plausible as these theories may be in explaining that wild week or so in early April, it's far from clear that the narratives around cracks in U.S. exorbitant privilege and equity outflows are still reasons to bet against the dollar going forward. As far as the former is concerned, America's brand may suffer additional damage from Trump's overt threats to Fed independence. But we're talking about a very nuanced change: a move from an extraordinarily special status in global markets to just very special.
In practice, there's still no viable alternative to U.S. debt and its currency. European debt markets lack our market depth and China lacks our transparency, while Bitcoin is as volatile as a tech stock. Meanwhile, a solid streak of Treasury auctions has more or less ended the debate about caution among overseas investors. In the U.S. equity market, the panic is in the rearview mirror. Since bottoming on April 8, the S&P 500 has returned to all-time highs and is again outperforming the rest of the developed world's markets.
The story isn't over, though. While the dollar hasn't weakened much more from its April lows, the durability of the move makes it more likely that currency weakness will have a meaningful impact on the economy, including consumer prices. In recent weeks, the greenback seems to have resumed its typical correlation with Treasury yields, opening the door to further declines if markets begin to price in significant rate cut expectations.
That's why the Fed needs to proceed with extreme caution. Policymakers shouldn't lower borrowing costs and implicitly weaken the exchange rate until they can be sure that higher consumer prices aren't already in train.
Without question, they should hold rates at their July meeting and the inflation data would need to stay quite tame to justify a cut at the subsequent meeting in September, at least in the absence of a labor market deterioration. The tariff experiment, coupled with the shock exchange-rate reaction, is an event study unlike any other in recent memory and the stewards of stable prices can't take anything for granted. Even if prices do jump, it's still possible that the uptick won't lead to a lasting increase in the rate of inflation and the Fed can eventually get on with easier monetary policy. But at this point, the responsible option is to wait and see how it plays out in the data.
Jonathan Levin is a columnist focused on U.S. markets and economics. He is a CFA charterholder.