Note to President Trump: It's Policy Divergence, Not China, Driving the Dollar

President Trump is worried about the strong dollar:

In his interview with the Journal on Friday, Mr. Trump said the U.S. dollar was already “too strong” in part because China holds down its currency, the yuan. “Our companies can’t compete with them now because our currency is too strong. And it’s killing us.”

The real issue is not China but the diverging of the current and expected paths of monetary policy among the major advanced economies, particularly the United States and Europe. The Fed has been tightening and is expected to continue do so with further rate hikes in 2017. The ECB, on the other hand, is still running its QE program and is keeping it short-term policy rates pegged close to zero. 

This policy divergence can be seen in the figure below. It shows the 6-month interest rate, 6 months ahead for the United States minus the same measure for the Eurozone (blue line).¹ Ever since mid-2014 this spread has been rising--with a brief plateauing in 2016--and the trade weighted dollar (red line) has closely followed it.

Source

Part of the divergence between the expected paths of monetary policy comes from the belief that Trump's policies will spur robust growth. This belief may prove premature, but if it does come to fruition it will only reinforce the policy divergence by pushing interest rates higher.  Going after China will not change this policy divergence. 

The surging dollar, if anything, creates more problems for the rest of the world than for the U.S. economy.  It is something to worry about, as I have noted before, because there is a lot of foreign debt denominated in dollars and because other currencies tied to the dollar will also strengthen.  But this is a very different problem than the one President Trump sees with the strong dollar. 

¹ I calculate this 6 month interest rate, 6 months ahead as follows.

Using the expectation theory of interest rates, we know that

 1-year rate_t = (6-month rate_t +6-month rate^e_t+1 )/2 + term premium_t    (1). 

Rearranging (1) we get

 2 x 1-year rate_t - 6-month rate_t  = 6-month rate^e_t+1  + 2 x term premium_t    (2).

The Fred database has data for the left hand side of the equation (2) for both the United States and the Eurozone. So that we can calculate the following spread:

         (2 x 1-year rate_t,USA - 6-month rate_t,USA) - (2 x 1-year rate_t,EUR - 6-month rate_t,EUR)    (3),

which, according to (2), is equal to the following;

(6-month rate^e_t+1,USA +2x term premium_t,USA) - (6-month rate^e_t+1,EUR +2x term premium_t,EUR) (4). 

Since the 6-month yield, 6-month ahead term premium should be fairly similar for the two regions, this term drops out and leaves us with the desired spread:

6-month rate^e_t+1,USA  - 6-month rate^e_t+1,EUR  = expected policy divergence (5) .