Contradictory Policies and a Weaker Dollar

But the dollar is surprisingly weak, and while U.S. President Donald Trump ignores this as unimportant, markets see the situation differently.

The question is whether this weakness is simply cyclical, or whether it reflects new structural vulnerabilities associated with shifts in domestic politics. If America faces a fundamental loss of confidence due to the administration’s attacks on the rule of law, its erratic decisions and ballooning budget deficits, then the dollar’s long-term role as an anchor for the global economy could be at risk.

U.S. policy uncertainty

The loss of political credibility will come as no surprise. Key components of the Trump administration’s strategy are contradictory. Tariff threats and the use of trade and financial ties as weapons contradict the strategy of growing the economy by accelerating technological progress and capital deepening (thanks to AI infrastructure).

Even if the duties end up being small and do not cause too much direct damage, and even if the U.S. trade deficit remains at manageable levels, uncertainty will remain.

This strictly U.S. uncertainty is reflected in the country’s political risk assessment, which in turn affects the dollar.

This phenomenon is well known in developing countries, where currencies tend to weaken under populist governments. The empirical literature shows that weak institutions, discretionary fiscal behavior, and political interference in the central bank invariably undermine financial stability.

Moreover, these dynamics often lead to inflation, capital flight, and persistent devaluation, even with a floating exchange rate. The combination of tariff threats and mounting political pressure on the U.S. Federal Reserve creates a similar macroeconomic configuration that analysts have previously associated only with countries with weak currencies.

The U.S. is not the only developed country where populism has weakened currencies. Look at Japan, where the central bank’s recent interventions in the foreign exchange market have failed to stop further devaluation of the yen. While there is a popular market perception that America is tacitly supporting these efforts (the Trump administration has stated that it would prefer to avoid a strengthening of the dollar against the yen, and so markets have assumed the likelihood of joint interventions), the Bank of Japan has failed because that country too has gone down the path of populist economic policies. When a country already has a high public debt burden (as Japan and the U.S. do), expansionary fiscal policy tends to reduce the credibility of any currency intervention.

Trump’s duties are cut from the same populist cloth. But the US administration has nevertheless taken this economically damaging path. The reason is its bet that the AI boom will deliver rapid productivity growth and lower inflation before the new election cycle begins. As is always the case with populism, the political calendar comes first.

But even if this bet pays off in the short term, the damage is already done. Tariff threats (whether they materialize or not) are already weakening the dollar. They have created uncertainty in financial markets, altered investment portfolios, and created expectations that duties could be imposed at any time and for any reason. If one of the Trump administration’s goals was to weaken the dollar through tariff threats, it has been achieved.

Institutional erosion

While actual duties can lead to short-term currency appreciation, threats to impose them typically weaken the currency. This increases US-specific uncertainty, and hence the risk premium for the dollar. The situation is exacerbated by the fact that the Federal Reserve, which normally acts as a counterweight, is now facing a problem usually peculiar to developing countries: weakening institutional independence. Trump’s public pressure on the Fed’s leadership through threats of legal action, demands to cut rates at politically advantageous times, and attempts to narrow the scope of regulation are all taking away the Fed’s ability to act decisively.

When central banks are pushed into pro-cyclical or politically convenient decisions, the result is higher inflation and weaker currencies.

Take a look at Turkey between 2021 and 2023. Repeated monetary policy interventions by the authorities drove inflation from below 10% to over 80%, causing the currency to plummet and requiring costly efforts to restore confidence.

The crises in Argentina followed a similar scenario. When monetary authorities lose autonomy, extreme measures that cause severe economic pain have to be taken to restore market confidence.

Yes, the US is not Turkey or Argentina. America has deeper markets, a stronger institutional system, and the privilege of issuing the world’s dominant reserve currency.

But these advantages should not be confused with invincibility. Institutional erosion is continuous. The earliest signals, however subtle, are important. Even moderate doubts about the Fed’s independence can push up risk premiums, change the dynamics of exchange rates, and weaken the stabilizing role of U.S. monetary policy in the world.

Dollar weakness could be costly

Recent fluctuations in gold and silver prices reflect these concerns. Their sharp rise has been attributed by many to a desire to guard against weakening Fed independence and geopolitical controversies. And their fall after Trump nominated Kevin Warsh to chair the Fed showed that markets are now factoring political uncertainty in America into prices in the same way they do for countries without a reserve currency.

American businesses should be wary. Firms that thrive on political connections, regulatory favoritism or temporary tax advantages can reap big short-term gains. But weakening macroeconomic fundamentals will erode their profits over time – even in an economy super-accelerated by AI. Investor optimism about AI’s transformative potential is already being replaced by uncertainty, and with it, expected volatility, regardless of whether the sector ever corrects.

The international implications are no less significant. Many developing countries remain dependent on dollar-denominated financing and are therefore sensitive to changes in U.S. financial conditions. A weakening dollar may give them temporary respite, but duties and other uncertainties associated with U.S. policy deter foreign direct investment and make it more difficult to implement development strategies in poorer countries.

While the Trump administration assures that America can devalue the dollar while maintaining its reserve currency status (through tariff threats, currency intervention, or closer coordination between the Treasury and the Fed), Japan’s experience, with its attempts to control the yield curve and manage the currency, serves as a cautionary tale.

When monetary and fiscal authorities conflict and simultaneously attempt to target both the exchange rate and long-term yields, risk premiums tend to rise rather than fall.

Confidence in economic policy takes decades to build, but it can be lost quickly. The chain of cause and effect does not lead from inflation to loss of confidence and currency depreciation. On the contrary, it leads from weakening institutional independence to weakening inflation control and then to loss of confidence.

The question is whether America is willing to learn this lesson before the costs become much more difficult to prevent or absorb, not only for the U.S. economy but for the global economy as well.

Şebnem Kalemli-Özcan

Şebnem Kalemli-Özcan, Professor of Economics at Brown University, Director of the Global Linkages Lab (GLL), former Senior Policy Advisor at the International Monetary Fund, former Lead Economist for the Middle East and North Africa at the World Bank.