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The Vise Tightens on the Dollar

In the second quarter of this year, the US experienced the sharpest plunge in domestic saving on record, dating back to 1947. Because that will continue, and the current-account balance is following suit, the dollar's real effective exchange rate can head in only one direction.

NEW HAVEN – The US dollar has now entered the early stages of what looks to be a sharp descent. The dollar’s real effective exchange rate (REER) fell 4.3% in the four months ending in August. The decline has been even steeper as measured by other indexes, but the REER is what matters most for trade, competitiveness, inflation, and monetary policy.

To be sure, the recent pullback only partly reverses the nearly 7% surge from February to April. During that period, the dollar benefited from the flight to safety triggered by the “sudden stop” in the global economy and world financial markets arising from the COVID-19 lockdown. Even with the recent modest correction, the greenback remains the most overvalued major currency in the world, with the REER still 34% above its July 2011 low.

I continue to expect this broad dollar index to plunge by as much as 35% by the end of 2021. This reflects three considerations: rapid deterioration in US macroeconomic imbalances, the ascendancy of the euro and the renminbi as viable alternatives, and the end of that special aura of American exceptionalism that has given the dollar Teflon-like resilience for most of the post-World War II era.

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