Fed Independence and the Dollar

The Dollar has ignored mounting pressure on the Fed and is up 2 percent this month

The Dollar is up 2 percent this month, confounding all the Dollar bears that are out there. What’s wrong-footed people in particular is that there’s lots of tariff headlines, which in recent months dragged the Dollar down, but that’s not happening now. As I laid out in a post over the weekend, the only tariffs markets care about are between the US and China. It’s that trade conflict that escalated out of control in early April, caused serious wobbles in the Treasury market, and prompted a sharp decline in the Dollar. Markets don’t think any other country is systemic, not even Japan or the EU. Everyone else is just along for the ride.

But recent criticism of the Fed is worrying. All the recent experience from emerging markets - I discussed the case of Turkey in a recent post - is that loss of central bank independence can cause currencies to go into serious free fall. So it’s all the more confounding that markets have ignored mounting pressure on Chair Powell.

The chart shows the trade-weighted Dollar against other advanced economies so far this month. It’s up two percent and bounced back after yesterday’s headlines that the President discussed firing Chair Powell with Republican lawmakers. There’s two possible explanations for this. The first is that markets see little difference between Powell and possible replacements. All the names that are in the running, which at this point are primarily Kevin Hassett, Kevin Warsh and Scott Bessent, are highly credible policy makers and thus - in the eyes of markets - would preserve independence of the Fed. The problem with this view is that firing Powell would undermine the Fed at an institutional level, which would weigh on the Dollar. The second explanation, which I think is more likely, is that markets don’t think the President is serious about firing Chair Powell. After all, this could reignite turbulence in the Treasury market. It was such turbulence that caused the US to back down in its tariff fight with China a few months ago. It’s more likely that Powell is a useful foil as the economy weakens under the weight of tariffs. If that’s the case, better to keep Chair Powell around rather than get rid of him.

So what about the Dollar? I’ve argued that its decline so far this year is largely cyclical and reflects excessively dovish market views on the Fed. This week’s CPI showed that inflation is clearly picking up in imported goods, an effect that’ll keep mounting in coming months. This is likely what’s behind the rise in the Dollar and there’s plenty more Dollar strength to come from this source. It’s also notable that all the talk about a loss of reserve currency status has subsided. Markets have accepted that the hurdle for any such loss is extremely high and that the Dollar fall is cyclical, not structural. As it becomes increasingly clear that the US isn’t going into recession - and with rising inflation - the odds are that the Dollar will keep rising.