Estimates of Fundamental Equilibrium Exchange Rates, May 2017

William Cline

No PB17-19, Policy Briefs from Peterson Institute for International Economics

Abstract: The latest estimates of fundamental equilibrium exchange rates (FEERs) find the most important currency misalignment is that of the US dollar, which remains overvalued by the same amount as in November 2016, about 8 percent. The political and monetary forces presently affecting exchange rates shows considerable risk that the dollar will rise further. Upward pressure on the dollar seems likely to persist as the United States moves toward monetary normalization on a faster track than the euro area and Japan, leading to rising interest differentials that could be exacerbated by a move toward major US fiscal stimulus. The tax reform plan outlined by the Trump administration at the end of April could cause such a stimulus, considering that it would cut revenues by about 2 percent of GDP. Even achieving the steady 3 percent growth envisioned by the tax proposal authors would be unlikely to recover more than about one-third to one-half of the direct revenue loss. If fiscal reform adopted the border tax adjustment proposed by House Republicans, the deficits might be somewhat smaller, but there could be a sizable exchange market shock strengthening the dollar.

Date: 2017-05
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