Can a stronger dollar cancel out tariffs?

The US Dollar Index (DXY) has climbed back towards 107 since the election, and trade economists are asking an old textbook question. Can a stronger dollar cancel out the inflation from new import tariffs? In theory, tariffs push up the currency, which makes foreign goods cheaper and offsets the border tax.

The move has been quick. The index stood close to 100 at the end of September, when markets expected the Fed to keep cutting steadily and the election looked like a coin toss. Strong American data in October began the rally, and the Republican victory extended it, as investors priced in tariffs, larger deficits and a Fed that would stop cutting sooner. The euro and the Mexican peso have fallen sharply, and the renminbi has weakened since polling day.

How the textbook offset works

The logic runs through trade flows and interest rates. A tariff cuts American demand for imports, so fewer dollars are sold for foreign currency, and if the duties add to inflation the Federal Reserve eases more slowly and dollar assets pay more than their rivals. Both forces lift the exchange rate. In the cleanest version of the model the currency rises by the full amount of the tariff, and the dollar price of imports does not change at all.

The index itself is a poor gauge of that offset. The DXY is dominated by the euro, with smaller weights for the yen, sterling, the Canadian dollar, the Swedish krona and the Swiss franc, and it contains neither the renminbi nor the Mexican peso. The currencies of the countries most exposed to the promised tariffs are not in it at all.

The model also assumes that nothing else changes, which is rarely true. Tariffs invite retaliation, which cuts American exports and pushes the other way on the currency. They can slow growth abroad, prompting foreign central banks to cut rates and weaken their own currencies further. And they raise uncertainty, which tends to push money into dollars as a haven regardless of trade flows. The net effect on any single exchange rate is hard to predict, even if the direction for the dollar as a whole is fairly clear.

Lessons from the last trade war

The first Trump administration offers a partial test. As tariffs on Chinese goods rose in 2018 and 2019, the renminbi weakened and in August 2019 crossed seven to the dollar for the first time in more than a decade. The currency move did little for American buyers. Studies of import prices found that nearly all of the cost of those tariffs was passed through to American importers and their customers rather than absorbed by foreign exporters.

Invoicing explains part of the gap. Most goods sold to the United States are priced in dollars, so a foreign supplier's price does not fall automatically when its own currency weakens; it falls only if the supplier chooses to cut it. Many prefer to pocket the wider margin, at least until contracts come up for renewal.

The dollar did rise during that episode, gaining several per cent against a basket of currencies over 2018 as the Fed raised rates and tariffs escalated. That rise helped contain the jump in import prices at the margin. It did not stop the cost of tariffed goods from rising for American buyers, and it hurt exporters of farm goods, who faced both a stronger currency and Chinese retaliation at the same time.

Only a partial offset

A stronger dollar does cut the cost of imports that escape the tariff. It works with long and uneven lags, though, and cannot make up for rates of twenty-five to sixty per cent. A rising dollar also tightens financial conditions worldwide and squeezes emerging markets that borrow in dollars. American exporters lose ground as well. Counting on the currency to absorb tariff inflation is a risky bet.

Who pays for a strong dollar

The costs land outside the tariff wall as well as inside it. Governments and companies in emerging markets that borrowed in dollars face bigger repayments in local-currency terms, and their central banks may have to hold rates up to defend their currencies. Europe and Japan gain a competitive edge for their exporters but import more inflation through oil, which is priced in dollars. At home, multinationals report smaller profits once foreign revenue is translated back, and manufacturers that compete with imports find their tariff protection partly cancelled by the exchange rate.

That last effect tends to turn into a political problem. In the early 1980s high American interest rates drove the dollar up so far that manufacturers lobbied hard for protection, and in September 1985 the Plaza Accord committed the G5 to push it down. In his first term Donald Trump complained repeatedly about the strength of the dollar, which sits awkwardly with policies that tend to strengthen it.

For the Fed, a stronger dollar is a mixed blessing. It lowers the price of imports and tightens financial conditions, doing some of the central bank's work. It also weighs on growth by hurting exporters and multinationals. Officials will watch how much of the tariff is being absorbed before deciding how far to cut. A rise of several per cent in the dollar would shave something off inflation over the following year, but not enough to offset duties several times larger.

The indicators to watch are the daily fixing of the renminbi by the People's Bank of China, the gap between American and European two-year yields, and monthly import prices excluding fuel. If the renminbi weakens sharply once tariffs are announced, the offset for Chinese goods will be larger than the index suggests. If import prices rise despite a strong dollar, the offset will have failed.

Where the textbook may win

The best case for the offset is that currency markets move far faster than prices in shops. The dollar has already risen on the expectation of tariffs, before a single duty has been imposed, so some of the cushion is banked in advance. If the duties turn out closer to the 10 per cent universal levy floated in the campaign than to the higher rates, a firmer dollar could absorb a meaningful share of the cost. The column's doubt rests on scale, and on whether Beijing again lets the renminbi slide, which would do more to soften duties on Chinese goods than any move in the index.

A stronger dollar might take the edge off tariff inflation for American shoppers. It will not stop prices rising once duties that high disrupt supply chains, and exporters will pay for the currency's strength in lost sales. Expect import prices on tariffed goods to rise within two quarters of any new duties, whatever the dollar does.