Is the US dollar already being undermined?

That’s not what is supposed to happen, nor what the Trump administration expected to happen.

The theory and history say that, when tariffs are imposed, the currency of the country imposing them strengthens and to some extent blunts the impacts of the tariffs on its own consumers and companies, who (despite what Trump claims) are the ones who actually pay the tariffs in the form of increased prices.

A 2019 International Monetary Fund study of 151 countries between 1963 and 2014 showed that tariff increases did result in real exchange rate appreciation. (It also showed, despite what the Trump administration believes, that the tariffs had only a modest effect on trade balances).

There’s a simple explanation for why the US dollar should be rising. Tariffs raise the prices and therefore reduce the demand for imports, which means there’s less need for US companies to exchange dollars for imported goods, fewer dollars in circulation and, with less supply, higher “prices” for the currency.

The fact that hasn’t happened could be due to a number of factors.

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An obvious one would be that investors and traders believe the US is shooting itself in the foot and that the damage to its economy will be greater than that on the economies they are shifting their exposures too.

The tariffs will lower US growth, employment and investment and lift the inflation rate, risking stagflation, or higher inflation with lower growth.

That was what the Federal Reserve Board chair, Jerome Powell, was alluding to last week when he said tariffs were likely to generate at least a temporary rise in inflation, but it was also possible that it could be more persistent.

The Fed had a bruising experience with what it thought was going to be the “transitory” spike in inflation caused by the pandemic’s impact on global supply chains. Four years after US inflation started to surge, it remains elevated and above the Fed’s target even as the US economy has slowed and before Trump’s tariffs and their negative impacts on inflation and growth hit home.

In the past, the dollar has strengthened even during US recessions, so the immediate reaction to Trump’s tariffs and the big bets against the dollar mounting in futures markets suggest there is something different this time.

The tariffs, the assault on the global free trade order that the US built and encouraged (and profited from) and the trade war Trump has initiated, against not just perceived foes but America’s closest trading partners, geopolitical allies and the poorest economies in the world, might be undermining the dollar’s status as the world’s reserve currency.

There might be a developing structural element to the dollar’s unusual response, driven by a backlash against Trump’s actions, which underscore the vulnerability of other economies, have heightened mistrust of America and have raised question marks over the longer-term potential of its economy.

It doesn’t help that, even as the punitive and irrational tariffs regime is being implemented, the Republicans in the Senate have introduced Trump’s “big, beautiful bill” of tax breaks and spending cuts, a bill the nonpartisan Committee for a Responsible Federal Budget says would add $US5.8 trillion to US primary deficits between 2026 and 2034 and which it says would be “historically unprecedented in its fiscal irresponsibility”.

The bill would not only extend the $US4.5 trillion of tax cuts for the wealthy from Trump’s first term, which are scheduled to expire later this year, but had more than $US1.5 trillion for the abolition of tax cuts on tips and other pledges Trump made during the election campaign.

The tariffs will lower US growth, employment and investment and lift the inflation rate, risking stagflation, or higher inflation with lower growth.

When added to the impact of the tariffs on the economy, the massive increase in America’s already daunting debt and deficit burden is occurring at the most delicate moment in the country’s post-war history.

The dominance of the US dollar in global trade and finance has meant that, regardless of domestic economic conditions or policies, the US has been able to attract foreign investment to its markets and economy.

Foreign governments have seen it as a safe and stable place to park their savings, investors have seen it as a source of higher and less volatile returns and companies have acquired US dollars in exchange for the goods they have sold into the world’s largest consumer market.

Now the world doesn’t see America as safe or stable, and the tariffs mean US corporate profits will fall, as will the need for investment capital, and the market for foreign goods will shrink.

The US has, since 1944, enjoyed what the former French finance minister, Valéry Giscard d’Estaing, once termed an “exorbitant privilege”. It costs almost nothing to print a dollar, but other countries have to supply $US1 of goods or services to acquire one.

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That has underpinned a period of more than 80 years when the rest of the world has effectively subsidised the US economy and its citizens’ standards of living. Regardless of its economic fundamentals, it has been able to borrow more cheaply, buy goods more cheaply, leverage the dollar into geopolitical dominance and never have to fear a balance of payments crisis because the dollar status has effectively given it unlimited foreign exchange reserves.

America’s economic strength and stability revolve around the dollar’s status and privileges. Could Trump, his tariffs, the plan for massive increases in US deficits and debt undermine the dollar’s dominance and create an economic and financial crisis in the US in the process? We may be about to find out.

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