True to form, President Trump, once again, confuses the public discourse on trade by tying currency adjustments to U.S. domestic monetary policy.

The U.S. Administration is threatening to turn back the clock to the 1930s with a spade of tariffs aimed, initially, at China and extending to the EU. He views international trade as if it were a sporting match in which one side is “down a tremendous amount” and therefore the “losing side” must do something to get back into the game. Earlier this month, the United States imposed levies totaling $50 billion on selected Chinese exports of machinery, components, and electronics. The Administration has identified a further $200 billion in Chinese exports targeted for tariffs, for a total of $250 billion or more than 50% of all Chinese exports.

In addition to tariffs, Trump has returned to one of his favorite whipping boys-----currency manipulation. He accuses China and the European Union of manipulating their currencies to hurt the United States on trade. This accusation is not new, but he adds a further wrinkle to the argument in attacking the Fed for raising rates, thus contributing to the rising USD. Which is it? That U.S. trading partners deliberately depress the value of their currencies or that the Fed is responsible for the rise of the USD? Now, Trump is saying the answer is both.

The USD is also responding strongly to the Fed’s determination to raise short-term rates. A long-standing policy of the Fed is never to set domestic interest rates with a view to how they influence the dollar. In this regard, the Fed is following its stated goal of raising rates gradually to reflect employment and inflationary conditions at home. In keeping with tradition, the Presidency refrains from commenting on Fed decisions out of respect for its independence. The financial markets rely on this independence and loath political interference in setting monetary policy. Now, Trump has put the Fed up a tree when it comes to future deliberations on whether to raise rates again. Not raising rates could be interpreted as bowing to political interference; raising rates could provoke more calls to harness the Fed’s independence.

Trump has now tied currency manipulation --- via interest rate moves—to the Federal Reserve independence is setting rate policy.  In one sweeping statement, Trump lumps currency and interest rates together when he claims that “China, the European Union, and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars gets stronger and stronger with each passing day - taking away our big competitive edge”.

Figure 1 Trade-Weighted US Dollar Index

A rising USD reflects strength at home and weakness abroad ( Figure 1). The U.S. economy is doing well and is implementing a fiscal expansion policy through massive tax cuts which have the potential to raise domestic capital investment and stimulate growth.  China’s currency has weakened in recent months as that nation undergoes a slowdown and significant efforts to reduce domestic corporate debt; deleveraging can have a powerful affect on the external value of the yuan. Furthermore, the yuan is under pressure from growing uncertainty regarding future U.S. tariff moves. It is a matter of debate whether the yuan’s decline has been propelled by markets turning more cautious or whether the Chinese government has actively intervened to support exports.  As for the EU, that region continues to exhibit all the signs of sluggish growth and weak inflation compared to the U.S. performance, giving every reason for their interest rates to remain well below those of the United States.

In sum, each trading region is responding to domestic growth considerations when setting monetary policy. As the trade war heats up, expect currencies to adjust to counter protectionism and interest rates to reflect domestic economics conditions.