Conflicting policies, confused investors, the weak dollar

By ?ebnem Kalemli-Özcan

The United States has long been the principal engine of global growth, powered most recently by an AI boom that shows no signs of slowing. The dollar, still the central pillar of global finance, has funded this transformation. Yet the greenback has been surprisingly weak, and while US President Donald Trump dismisses this as unimportant, markets see it differently.

The question is whether this weakness is merely cyclical or whether it reflects emerging structural vulnerabilities tied to domestic political and policy shifts. If the US has suffered a fundamental loss of credibility because of the administration’s attacks on the rule of law, ballooning fiscal deficits, and erratic policymaking, the dollar’s long-term anchoring role in the global economy may be in jeopardy.

A loss of policy credibility would not be surprising. Key components of the Trump administration’s strategy conflict with one another. Tariff threats and the weaponization of trade and financial linkages are at odds with a growth strategy predicated on technological acceleration and capital-deepening (namely, AI infrastructure). Even if tariffs end up being small and do not inflict too much direct damage, and even if the US trade deficits remain manageable, uncertainty will endure.

Thus, US-specific uncertainty is generating political-risk differentials that in turn affect the dollar. This is a well-known phenomenon in emerging markets, where currencies tend to weaken under populist governments. The empirical literature shows that fragile institutions, discretionary fiscal behavior, and political interference in central banking consistently erode financial stability. These dynamics also often generate inflation, capital flight, and persistent currency depreciation, even under floating-exchange-rate regimes. The combination of tariff brinkmanship and mounting political pressure on the US Federal Reserve is creating a similar macroeconomic configuration that analysts once associated exclusively with weak-currency economies.

The US is not the only advanced economy where populism has weakened the currency. Consider Japan, where the central bank’s latest foreign-exchange intervention failed to halt further yen depreciation. Despite the widespread market assumption that the US would tacitly join the effort (given the Trump administration’s stated preference for avoiding a stronger dollar relative to the yen, which is why the market assumed a joint intervention in the first place), the Bank of Japan failed because the country, too, has embarked on a populist economic-policy path. When a country already has a large public-debt burden, as both Japan and America do, an expansionary fiscal policy tends to undercut the credibility of any foreign-exchange intervention.

Trump’s tariffs are cut from the same populist cloth. The US administration is pursuing this economically damaging path nonetheless, because it is betting that the AI boom will deliver rapid productivity gains and disinflation before the next election cycle. As is always the case with populism, the timing is political.

But even if this bet works out in the short term, the damage will have been done. Tariff threats – regardless of whether they are implemented – have already exerted a persistent weakening effect on the dollar. They have injected uncertainty into financial markets, altered portfolio allocations, and established an expectation that levies can be imposed at any moment, for any reason. If one of the Trump administration’s goals is to weaken the dollar through tariff threats, it has succeeded.

While actual tariffs can have a short-run currency-appreciation effect, tariff threats tend to weaken the currency by raising the US-specific uncertainty and hence the dollar’s risk premium. Making matters worse, while the Fed would normally act as a countervailing force, it now faces a challenge more commonly seen in emerging markets: erosion of its institutional independence. The public pressure Trump has applied through legal threats against Fed officials, demands for politically timed rate cuts, and efforts to narrow its regulatory remit undermine its ability to act decisively.

When central banks are pushed into pro-cyclical or politically expedient decisions, the result is ultimately higher inflation and a weaker currency. Consider Turkey’s experience between 2021 and 2023. Repeated political interventions in monetary policy drove inflation from under 10% to over 80%, causing a dramatic collapse in the currency and a costly effort to restore credibility. Argentina’s crises have followed a similar script. Once monetary authorities lose autonomy, regaining market trust requires extreme measures and considerable economic pain.

Of course, the US is not Turkey or Argentina. It has deeper markets, a stronger institutional framework, and the privilege of issuing the world’s dominant reserve currency. But these advantages should not be mistaken for invincibility. Institutional erosion operates on a continuum. Early signals, however subtle, matter. Even mild doubts about the Fed’s independence can push up risk premia, alter exchange-rate dynamics, and weaken the globally stabilizing role of US monetary policy.

The recent swings in gold and silver prices reflect these concerns. Their surge was widely read as a hedge against diminished Fed independence and geopolitical tensions, and their decline following Trump’s nomination of Kevin Warsh to serve as the next Fed chair showed that markets are now pricing US-specific policy uncertainty the same way they price that of countries that do not have a reserve currency.

American businesses should beware. Firms that thrive on political access, regulatory favoritism, or temporary tax advantages may enjoy a short-run windfall, but weakened macroeconomic fundamentals will eventually squeeze their profits – even in an AI-supercharged economy. Investor optimism about AI’s transformative potential is already giving way to higher uncertainty and, with it, higher expected volatility, regardless of whether the sector ever experiences a correction.

The international spillovers are no less significant. Many emerging markets remain reliant on dollar-denominated funding, making them sensitive to shifts in US financial conditions. A weaker dollar can be a temporary relief, but tariffs and other US-specific policy uncertainty deter foreign direct investment and complicate development strategies in poorer countries.

Although the Trump administration claims that the US can depreciate the dollar while still maintaining its reserve-currency status – through punitive tariffs, foreign-exchange interventions, or a tighter Treasury-Fed coordination framework – Japan’s experience with yield-curve control and currency management offers a cautionary tale. When monetary and fiscal authorities are in conflict and simultaneously attempt to target the exchange rate and long-term yields, risk premia tend to rise, not fall.

Economic policy credibility takes decades to build, but it can erode quickly. The causal chain does not run from inflation to lost credibility to weaker currencies; on the contrary, it runs from weakened institutional independence to impaired inflation control and then to a loss of credibility. The question is whether the US is prepared to internalize this lesson before the costs become much harder to reverse or cover up, not only for the US but also for the global economy.

?ebnem Kalemli-Özcan, Professor of Economics at Brown University and Director of the Global Linkages Lab, is a former senior policy adviser at the International Monetary Fund and former lead economist for the Middle East and North Africa at the World Bank.

Copyright: Project Syndicate, 2026.
www.project-syndicate.org

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