Peter Navarro, an adviser to President Donald Trump, told the Financial Times (subscription) Jan. 31 that Germany is using a “grossly undervalued” euro to “exploit” the United States. During a meeting with US business leaders, President Trump echoed Navarro’s remarks, complaining that “we sit here like dummies” while other countries manipulate their currencies.
This view is sadly at variance with all the observed facts.
The US dollar is strong and the Euro is weak because the Federal Reserve has been raising US interest rates and is expected to raise them further. The dollar is the world’s largest capital market. The dollar dog wags the euro tail. During the past three years, virtually all the change in the euro-dollar exchange rate is explained by the expected overnight interest rate set by the Federal Reserve (the federal funds rate) 12 months hence. The futures market for federal funds tells us what the market thinks the Fed will do.
Federal funds futures (expected Federal Reserve policy) explain the exchange rate between the US dollar and the euro. The chart above shows daily data for the past three years (from Bloomberg). As Fed policy has tightened, the dollar’s exchange rate has risen. Dollar holders receive higher interest rates vs. euro dollars, so investors shift deposits from euros to dollars. That’s what the textbook says should happen. I presume that is true even at Harvard, where Peter Navarro studied.
The above chart shows the Euro/USD exchange rate vs. the US government note 10-year yield and the German government bond 10-year yield. The former is a nearly straight line; the latter is all over the map. We observe that US yields, not German yields, track the euro, which is another way of saying that US monetary policy, not German monetary policy, determines the euro-US dollar exchange rate.
Don’t German interest rates matter? Not so much, in fact, because German bond yields tend to follow US yields. US yields jumped after the November election because investors thought that the incoming Trump administration would produce higher economic growth, which normally means higher interest rates.
If Prof. Navarro wants a cheaper dollar (presumably to benefit US exports), he needs to persuade the Federal Reserve to lower interest rates rather than raise them. I don’t think he would get very far with the Fed, but that is his affair. Germany has relatively little control over its exchange rate with the dollar; the dollar is the biggest money market and the world, and dollar interest rates determine the dollar’s value. The data show clearly that US monetary policy is the main influence on the dollar exchange rate, not some occult magic trick practiced by the financial wizards of Frankfurt.
I am all for protecting American workers against unfair trade practices, for example by requiring 100% domestic content for sensitive defense goods, as Henry Kressel and I argued in the Wall Street Journal (subscription) Nov. 21. Navarro simply has his facts wrong, and arguing from wrong facts never ends well. The dollar has risen during recent weeks in anticipation of the new administration’s success. Washington can’t have it both ways: It can’t succeed in making the US a more attractive venue for investments and cheapen the dollar at the same time.