What is surprising, however, is that investor expectations about monetary policy have shifted. Following the election, an expectation of lower taxes, less regulation, higher tariffs, and less immigration led to expectations of higher inflation. This, in turn, led futures markets’ implied probability that the Fed would cut rates several times in 2025 to decline sharply. It became conventional wisdom that the Fed would engage in a wait and see policy for much of 2025, possibly cutting rates only once if at all. Yet lately, expectations have changed, and the futures markets are now predicting as many as three rate cuts in 2025. What happened?
The answer is that the policy of tariffs, combined with uncertainty about tariffs, have led to increased angst on the part of many business leaders. Indeed, the composite purchasing manager’s index (PMI) for the United States fell sharply in February from the previous month, hitting a 17-month low, suggesting an expectation that the US economy will soon start to decelerate if not contract. If the US economy slows down or contracts, that would likely necessitate an easing of monetary policy. Recall that the Fed has a dual mandate from the US Congress: It must minimize inflation while maximizing employment.
Also, it is notable that once the tariffs were implemented the value of the dollar did not rise sharply as normally expected. Here is why the dollar ought to rise: The trade deficit is due to an excess of investment over savings. When a country invests more than it saves, it must experience an inflow of foreign capital to make up the difference. This requires that foreigners accumulate excess dollars. This happens when foreigners sell more to the United States than they purchase (a trade surplus for the foreigners). Thus, if tariffs are introduced, which initially cut demand for imports, there is a drop in demand for foreign currency, thereby boosting the dollar. In addition, something must happen to maintain the trade deficit so long as the gap between investment and savings endures. A rise in the value of the dollar will boost imports and reduce exports, thereby preserving the trade deficit.
The recent experience, however, is troubling. Although the dollar rose sharply against the Mexican peso when the tariffs were introduced, the dollar movement against other major currencies was more muted than expected. Why?
One reason for dollar softness is that investors now see a significant likelihood of a slowdown in the US economy. All other things being equal, a weaker economy means a weaker currency. Plus, the expectation of a weaker economy has led to an expectation of an easier monetary policy. That, too, implies a weaker currency. Thus, the future trajectory of the dollar could be different than previously anticipated.
Another factor driving down the dollar could be the decision by Germany’s two largest parties to engage in massive borrowing to fund defense and infrastructure. This has led to a rise in European bond yields, thereby boosting the value of the euro. Also, investor expectations regarding actions by both the US Federal Reserve and the European Central Bank have shifted substantially in the past few months.
One possibility is that investors are becoming worried that the dominant role of the dollar will decline amid a weakening of the global trading system. Previously, the United States was one of the world’s most open economies, playing a role as the market of last resort for the world’s producers. It also provided a safe haven for investors experiencing risk elsewhere. Yet now, some investors worry that a world in which large trade barriers are erected might become a world in which the dollar is far less attractive.
On the other hand, there is no currency that can easily substitute the role currently played by the US dollar. The United States has a massive, deep, and liquid market for easily substitutable government securities, something the euro lacks. China has capital controls, which makes it nearly impossible for the renminbi to play a major role. No other currency has sufficient scale to challenge the US dollar.
- Investors have been shifting funds toward lower-risk assets as uncertainty, especially regarding tariffs, undermines confidence. Equity prices have been falling, with the Magnificent Seven down 16% from its peak. The tech-heavy NASDAQ index is down 10%. Meanwhile, funds have been pouring into money market funds, which hit a record high volume this week.
The decline in equities reflects not only concern about the potential economic cost of tariffs, but the chilling effect of tariff uncertainty. Consider that, in recent weeks, large tariffs were imposed on Mexico and Canada and then mostly removed, but only for 30 days. There have been several policy reversals on tariffs. Plus, there have been several tariff proposals that have not been implemented. And there have been multiple reasons offered for imposing tariffs. As such, businesses don’t know what to expect and might fear making the wrong long-term decision about allocating capital. This is especially true for companies that must make large, long-term bets such as those in the automotive industry.
