In light of the possible policies of a second Trump administration, Deutsche Bank Research looks at the practical challenges associated with implementing a soft monetary policy. Analysts highlight the obstacles and limitations of such a strategy and argue that tariffs and their stronger implications for the dollar are more likely to dominate market outcomes.
Theoretical impact of a weak dollar policy
A soft monetary policy aims to weaken the dollar, possibly through interventions or capital controls. This would require exceptionally large interventions in financial markets, possibly involving trillions of dollars, or the implementation of costly capital controls. The analysis notes that a significant devaluation of the dollar, of up to 40%, would be necessary to close the trade deficit.
Challenges of unilateral foreign exchange intervention
Proposals to weaken the dollar include the creation of a foreign exchange reserve fund of up to $2 trillion. This strategy would require substantial additional Treasury debt and create a fiscal burden that could exceed $40 billion annually in net interest expenses. Such an intervention is likely to face significant political and practical hurdles, especially given the enormous scale required. Recent experiences, such as the spending of $63 billion by Japan's Ministry of Finance in just two days, highlight the enormity of the challenge. For this to have an impact on the dollar, at least $1 trillion would be needed, which is more than feasible.
Limitations of multilateral intervention
Multilateral intervention is limited by G7 commitments to market-determined exchange rates and the limited foreign exchange reserves of major economies. Apart from Japan, G10 central banks lack sufficient reserves for effective intervention. Historical examples, such as the Plaza Accord, involved significantly larger reserves and smaller capital markets compared to the current landscape.
Possible capital outflows
Another approach to weakening the dollar could be to encourage the outflow of U.S. capital. Historical attempts, such as those by Switzerland in the 1970s, have had limited success. Measures such as taxing foreign deposits or introducing residency-based requirements could be considered, but broad-based capital controls may conflict with Trump’s stated policy of maintaining the dollar’s status as the world’s reserve currency.
Erosion of the Federal Reserve's independence
Eroding the Fed’s independence could be the most impactful method of weakening the dollar, although this remains unlikely. Historical examples, such as the 2022 crisis in the UK, demonstrate how weakening central bank independence can lead to higher inflation risk premia and higher long-term yields. However, with only a few Fed appointments up for renewal and the need for Senate approval, this scenario seems unlikely.
While the Trump administration could exert rhetorical pressure on the dollar, implementing a policy of weakening the dollar would require substantial financial interventions, capital controls or a loss of independence for the Federal Reserve. Analysts suggest that tariffs and their implications for a stronger dollar are more likely outcomes.
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