US: Weaker dollar is here to stay – Capital Economics

Michael Pearce, Senior US Economist at Capital Economics, explains that after depreciating by almost 10% in trade-weighted terms since the beginning of 2017, they suspect that the dollar is set to remain relatively stable over the next few years.

Key Quotes

“The depreciation already seen will help support export growth and will boost core inflation by around half a percentage point this year.”

“Despite the mini-rally over the past few weeks, the dollar has remained on a steady downward trend and in trade-weighted terms is now 8% below its peak at the beginning of 2017. Using the more developedmarket focused DXY basket the decline has been even larger.”

“We had expected a step up in the pace of Fed tightening to trigger a rebound in the dollar this year. But the dollar has continued to fall despite a surge in US interest rate expectations and markets are now close to pricing in the four rate hikes we anticipate this year. Currency markets have instead been driven by other factors, including fading political risk in the rest of the world and the euro-zone in particular. We now forecast that the dollar will hold steady in trade-weighted terms over the next year or two, but will depreciate against many developed market currencies, including the euro, as rate tightening cycles come into view in those economies.”

“In that sense, a weaker dollar is another way in which stronger economic growth in the rest of the world is benefitting the US. Back in 2014 when the world economy was weaker, even the suggestion that the Fed would begin to raise rates triggered a big rise in the dollar, which ultimately tightened financial conditions and slowed economic growth and inflation. More broadly it is another sign that, a decade after the financial crisis began, the world economy is getting back to normal. Following a few years of dollar strength, in real trade-weighted terms the dollar is back in line with its long-run average.”

“Even if the dollar doesn’t move much over the next twelve months, the past depreciation will still have big effects on the economy this year. The recent spending deal, together with the tax cuts already passed, will provide a boost to domestic demand and import growth in the near-term. Ordinarily that would point to a much bigger current account deficit too. But the depreciation of the dollar suggests that export growth will accelerate as well, keeping the trade deficit in check. That suggests that the big drag on economic growth from net trade in the fourth quarter of last year will not be sustained in 2018.”

“We think the most notable impact will be higher inflation. The weaker dollar has already led to a pickup in imported goods inflation which is showing up in the producer prices data. The acceleration in core producer goods inflation is consistent with a boost to core CPI inflation of around 0.5ppts over the course of this year. With imported goods prices still rising, that boost will be sustained into 2019 too.”

“Of course, there are forces that could push the dollar higher again. We may be underestimating the impact of the deficit-financed stimulus on economic growth further ahead. But the biggest immediate risk is if President Trump were to follow through on his protectionist threats. The announcement on steel tariffs has not had much effect, but if the US were to withdraw from NAFTA, that would cause the dollar to surge against the peso and Canadian dollar. The resulting hit to growth and inflation may even be large enough to prompt the Fed to hold off raising rates.”