How Likely is Currency Offset to Occur?

The economic and market consequences of tariffs hinge on the extent to which they are matched by offsetting changes in currencies, so it is important to consider the likelihood that currencies do adjust. In the U.S.-China trade war of 2018-2019, currency offset was effective. However, there were several crosscurrents at the time that make the comparison cloudy.

For instance, the dollar was appreciating more broadly than just vs. China; during the period discussed above, the DXY dollar index maintained by the Intercontinental Exchange, which measures the dollar against other developed nations, also increased by about 10%. As mentioned above, currency moves in one pair can affect other assets too, just as an unwind in the yen carry trade affected all financial markets.

Given the significance of the USD-RMB pair to the global economy and markets, it is possible a good portion of the move in DXY was driven by the move in USD-RMB.

Such a possibility is bolstered by trends in interest rates over the period. The most powerful financial variable for explaining currency moves in developed markets is typically the spread in interest rates at the front end of the yield curve; market participants usually use two-year yields, but the convention varies depending on the interest rate and economic environment. In the period of the trade war, the yield advantage of UST securities was declining relative to the yields on other G7 debt; the spread declined from about 2% in January 2018 to about 1.65% at the trade war armistice in September 2019.

The decline in spreads occurred despite the rate hikes from the Federal Reserve over the course of 2018. This happened because markets marked down their expectations for future rate hikes as the economic data came in over the course of 2018. Of course, currency markets would typically follow changes in expected policy rather than the (already-priced-in) policy hikes occurring in real-time. A fully-expected change in policy should have no effect on currency markets. Thus it is highly unlikely the dollar appreciated because of monetary policy during this period; it appreciated in spite of monetary policy.

In 2025-2026, the yield spread of Treasury securities over other nations’ debt may narrow if the Fed continues its cutting cycle catching up to other central banks and the special factors boosting U.S. growth—like fiscal policy— further fade and U.S. growth converges down to the rest of the world’s. A declining-yield environment might make it more difficult for the dollar to rally to offset tariff hikes, although the experience of 2018-2019 shows currencies can move against interest rate differentials.

Alternatively, concerns over U.S. debt sustainability may come to the fore and prevent the dollar from appreciating to offset tariffs. The U.S. deficit for last fiscal year and this fiscal year are both near 7% of GDP9, during a peacetime expansion—an unprecedented degree of fiscal laxity. And with the Social Security Trust Fund set to run out of money in 203310, at which time the government will likely be forced to borrow to pay mandatory expenditures, budget woes draw inexorably nearer.

Since currencies always trade relative to each other, markets would have to become inordinately preoccupied with U.S. budget problems for this to prevent a rise in the dollar. Given many other nations’ precipitous demographic trends, they have severe budget problems lurking in their futures as well, even if their primary deficits are not projected to rise as much. Moreover, because tariffs raise revenue, deficit concerns are likely to be allayed by hikes in tariff rates, suggesting this is an unlikely channel to prevent appreciation.

A further reason the dollar might not appreciate as in 2018-2019 is if it starts from stronger levels. In 2018, the DXY index was at the bottom of its post-2014 range.

At writing, it is in the middle of that range. This would be more of a concern if the DXY was stretched near the top of its long-term range.

Finally, the dollar will be cross-buffeted by cyclical and secular changes to growth. There may be other changes which weigh on economic growth and prevent dollar appreciation. By contrast, former President Trump has expressed a desire to take steps to aggressively deregulate portions of the economy. If doing so serves as a boost to growth, it may provide further noninflationary support for the dollar.

Summing this all up, it is of course possible that currency offset does not occur in the next iteration of tariffs, but considering plausible reasons why that might be the case, offset seems more likely than not.

Tariff Implementation

A sudden shock to tariff rates of the size proposed can result in financial market volatility. That volatility can take place either through elevated uncertainty, higher inflation and the interest rates required to neutralize it, or via a stronger currency and knock-on effects thereof. President Trump, and those likely to staff his economic policy team, have a history of caring deeply about financial markets and citing the stock market as evidence of economic strength and the popularity of his policies. A second Trump Administration is likely therefore take steps to ensure large structural changes to the international tax code occur in ways that are minimally disruptive to markets and the economy. There are several steps that would help mitigate any adverse consequences.

Graduated Implementation

Even in the 2018-2019 trade war, President Trump didn’t implement 25% tariffs on Chinese imports in one swoop with no warning. He discussed these plans publicly and threatened China if it didn’t reform its trade practices, before implementing tariffs. Subsequent to open threats, they were implemented in such a manner that the roughly 18-point increase in effective tariff rates was spread over more than a year.

In going to 60% tariffs on China or 10% globally, such an approach becomes even more important. During his first Administration, President Trump sought to use tariffs to procure a trade agreement from China, which ultimately found shape in the “Phase 1” agreement—a commitment to improve practices on intellectual property, cyber security, nontariff barriers, openness to financial services, and purchases of agricultural commodities— that was subsequently violated and disregarded by China. Because tariffs are a negotiating tool, the President was mercurial in their implementation—the uncertainty over whether, when, and how big adds to leverage in a negotiation, by creating fear and doubt.

In a second term, there’s less cause to negotiate with the Chinese up front, since they already abdicated their responsibilities under the Phase 1 agreement. When someone has already demonstrated they walk away from their commitments, why bother trying to procure more, without some form of security—like placing their UST reserves in escrow?

Instead, to help minimize uncertainty and any adverse consequences of tariffs, the Administration can use credible forward guidance, similar to what is used by the Federal Reserve across a range of policies, to guide expectations. The U.S. Government might announce a list of demands from Chinese policy—say, opening particular markets to American companies, an end to or reparations for intellectual property theft, purchases of agricultural commodities, currency appreciation, or more.

The U.S. can proceed to gradually implement tariffs if China does not meet these demands. It might announce a schedule, for instance, a 2% monthly increase in tariffs on China, in perpetuity, until the demands are met. Such a policy will 1) gradually ramp tariffs at a pace not too different from 2018-2019, which the economy seemed able to easily absorb; 2) put the ball in China’s court for reforming their economic system; 3) allow tariffs to exceed 60% midway through the term, which is something President Trump has expressed wanting (“60% is a starting point”); 4) provide firms with clarity over the path for tariffs, which will help them make plans to deal with supply chain adjustments and moving production outside of China; 5) limit financial market volatility by removing uncertainty regarding implementation.

2018-2019 did not severely hobble China’s economy and bring back all its supply chains to the United States. In part, this is because it was a one-time shock to tariff rates, which was mostly offset by the currency. By contrast, a plan like the one set forth above would result in a perpetually rising tariff rate on a known and gradual path. That would likely instill much greater capital pressures on China and more rearrangement of supply chains.11 And with significant pressure on China, it is likely to achieve greater trade concessions. Critically, in the wake of their abdication of Phase 1 commitments, Chinese obligations under trade agreements should now be secured rather than unsecured.