Competitive devaluation would harm US, Brookings paper warns

US president Donald Trump should stop urging the Federal Reserve to weaken the dollar, researchers from the Brookings Institution argue.

Trump has strongly criticised the weakness of China and Europe, alleging they are purposefully keeping the value of their currencies low. He has frequently urged the Fed to step in to lower the greenback’s value by cutting interest rates.

Brookings researchers Adam Triggs and Warwick McKibbin examine the impact that a deliberate 6-12% reduction in the value of the dollar could have on the US economy, in line with the International Monetary Fund’s calculation of its fundamental value.

They find that devaluing the currency by lowering interest rates would only have a temporary effect. Such a move would cause inflation to rise and thus only result in a short-term depreciation of the real exchange rate.

“In the second year, the real effective exchange rate is only 1% below the baseline and then gradually returns to baseline over the following five years,” the authors say. Most of the initial consumption and investment boosts would also fade.  

The US trade deficit would  be “worsened, not improved”, weakening by 0.4% of GDP in the first year and by 0.1% of GDP in the second.

The authors also find China’s GDP would receive a boost due to the improved trade balance resulting from China’s real effective exchange rate becoming undervalued.

If a devaluation sparked a currency war with key trading partners, it would also have an impact on other countries, the authors say. This could cause “even more turbulence for capital and trade flows, exacerbating the investment and consumption effects”.

“If these are not the objectives of the US administration, then it would be wise to seek alternatives,” they conclude.