The U.S. economy has not faced such a tariff regime in nearly 80 years. It is in a situation without historical precedent and therefore without the possibility of “ready-made recipes.” Given the absence of recent historical precedent, the Federal Reserve is waiting for more evidence that consumer prices are not rising sharply due to tariffs before proceeding with interest rate cuts.
There is another reason for caution in these uncertain times: the highly unusual behavior of the U.S. dollar in the face of an impending currency war with China over the yuan. Many economists — including Stephen Miran, chairman of the President’s Council of Economic Advisors — expected the dollar to strengthen when President Donald Trump implemented the retaliatory tariffs on April 2.
In a study published in November, Miran wrote that the currency was “more likely to strengthen” than weaken as the U.S. trade balance with its partners improved — as it did during Trump’s first trade war in 2018-2019.
Currency hedging and the absence of inflationary pressures
Treasury Secretary Scott Bessent expressed the same view during congressional hearings. The so-called “currency offset” was a crucial parameter for his position that the new tariffs would not be fully passed on to consumers and would not trigger inflationary pressures.
It should be noted that currency hedging is a strategy used to minimize the risk arising from currency fluctuations. In essence, it is a method by which a company or investor “locks in” a specific exchange rate for a future transaction, thus protecting itself from unpredictable market movements.
Imagine a business in the EU that expects a payment in dollars from a customer in the US in three months. If the value of the dollar falls significantly against the euro by then, the European company will receive fewer euros than it had originally agreed to, reducing its profits. Currency hedging would allow it to avoid this risk.
It seems to be serving Trump’s seemingly contradictory goal of maintaining the US currency as a global reserve currency while reducing its value to address US trade deficits that triggered the infamous Triffin dilemma. This is the situation when the possession of a reserve currency by a country with high budget deficits and debt “suffocates” its productive base.
Surprisingly, the dollar has weakened — and the reasons for this are still the subject of heated debate among economists.
The U.S. Dollar Index has fallen 6.8% since just before the “Liberation Day” tariffs were announced on April 2 and has fallen about 10.4% in total in 2025, marking its worst year-to-date performance in at least 25 years. The median forecast of analysts surveyed by Bloomberg (July 22) is for the dollar to continue to weaken over the next 12 months.
Holding other things constant, one would expect the pressure on consumer prices to be even greater than the tariffs alone suggest. Economists have found in the past that, for a given change in the exchange rate of developed countries, the long-term “pass-through” to import prices is as much as 60% (for the US in particular, it is estimated to be around 40%). However, this pass-through depends on the economic context – and all else is never equal.
So far, inflation measurements have been subdued, either because the transfer will take time, or because retailers absorb the cost through lower profit margins, or because pessimistic forecasts were wrong. Probably all three – and that means that the Cassandras who predicted an inflationary tsunami (of the largest international media outlets included).
Given all this, it is wise to wait for “the data to speak” — just as Federal Reserve Chairman Jerome Powell plans to do. This angers Trump, who insists he can achieve both increased tariff revenue and immediate interest rate cuts at the same time. To do so, he is putting intense public pressure on the independent central bank and its outgoing chairman.
Why is the dollar weakening?
In April, many analysts interpreted the dollar’s decline as a sign of cracks in the so-called “excessive monetary privilege” of the United States. The idea is that the United States, with the deepest and most liquid asset markets in the world, has enjoyed a privileged position in the global financial system.
This special position has meant a slightly stronger currency and lower borrowing costs than they would otherwise have. When the dollar weakened alongside rising borrowing costs after April 2, commentators and academics argued that disorganized trade policymaking was tarnishing America’s “brand” internationally.
Another related argument has to do with capital flows. At the time of the tariff announcement, investors worldwide were heavily exposed to U.S. stocks, particularly the so-called Magnificent 7 (the top technology stocks).
From 2020 to March 2025, the S&P 500 outperformed other advanced economies by more than 2:1.
Global investors invested heavily in the U.S. market, often without hedging against currency risk. The hasty exit from these positions created a wave of outflows with significant macroeconomic impact.
As plausible as these theories may seem for the tumultuous week in April, it is far from clear that they remain sufficient to bet against the dollar in the long term. As for “excessive privilege,” perhaps America’s image has been tarnished by Trump’s threats to Fed independence — but these are subtle variations: from “extraordinarily special” to simply “very special.”
In practice, there is no truly viable alternative to US debt and currency: Europe lacks market depth, China lacks transparency, and Bitcoin is extremely volatile. The dollar will necessarily coexist with competing currencies in a multipolar monetary regime.
Currency War and the Threat of Sanctions
As global supply chains and trade continue to be restructured, Beijing is turning to another battleground: the Chinese yuan and its exchange rate against the U.S. dollar. Last month, Pan Gongsheng, head of China’s central bank, reiterated the regime’s interest in promoting the internationalization of the yuan, also known as the renminbi, at the Lujiazui Forum, a leading economic forum in Shanghai.
The dominance of currencies, especially in the digital world, will be the next focus of the U.S.-China trade war, according to Thanos Hondrogiannis, chief economist at Trust Economics (trusteconomics.eu). He noted that fear of sanctions has prompted the regime to try to expand the use of the yuan in an alternative cross-border payment system.
In support, U.S. Treasury Secretary Scott Bessent said Thursday 24/7 that his delegation would stress the importance of stopping purchases of Russian and Iranian oil when meeting with Chinese officials next week in Sweden. He said in an interview with Fox Business that he believes the United States can move forward on such issues involving China, given that bilateral trade has now “improved.” He made the remarks as senior U.S. and Chinese officials are set to meet on Monday and Tuesday (July 28-29) in Stockholm for a third round of trade talks.
Now, China is worried — and not unfoundedly — about potential sanctions before its digital currencies gain traction and wider adoption, he said.
The Politicization of the Financial System
In a speech in Shanghai in June, China’s central banker expressed concerns that “traditional cross-border payment infrastructures can easily be politicized, weaponized, and used as unilateral sanctions instruments” as geopolitical tensions escalate. Thanos Hondrogiannis reports that “economic sanctions and countermeasures will likely become a battleground for US-China competition in the next phase.”
The United States may start by imposing sanctions on some Chinese entities and then expand the scope, eventually excluding China from the dollar system. The BRICS’ “targeting of the dollar dethronement” poses a real and credible threat to the United States, which is why Donald Trump is imposing additional tariffs on these countries.
At a Cabinet meeting on July 8, US President Donald Trump said that the BRICS wanted to “destroy the dollar so that another country could take over and be the standard.” “If we lost the world position of the dollar, that would be like losing a war, a major world war,” Trump said. “We would not be the same country anymore,” he said, threatening an additional 10% tariff on those countries.
Ending Tariff Wars
Tariffs were a foreign language to most people when Trump began imposing retaliatory tariffs. Now, the world has accepted a minimum tariff of 10%, marking the triumph of his policy.
The final tariff numbers are not as important as establishing a new global order for international trade. A decentralized trading system that incentivizes capital flows into the United States was the bet of this trade policy. And that is something that was missing from the WTO (World Trade Organization).
At the start of Trump’s second term, the average tariff rate imposed by the United States was 3.4%, according to the World Trade Organization.
The global trading system has been characterized by low tariffs on exports to the United States, as well as significantly higher tariff rates or non-tariff trade barriers imposed by other countries.
For now, the US administration has extended the deadline for tariff negotiations from July 9 to August 1, with no further extensions. In the meantime, the base tariff rates remain at 10%.
Trump has since issued tariff letters to dozens of countries, setting their tariffs at between 20% and 50%. This method is described as the “blind box” method, meaning that the tariff rate is only revealed upon receipt of the letter – such an approach is “very effective” at “the lowest cost”.
Trump is sending a message that he is the one making the decisions and that other countries will be forced to comply – including China.
The New Cold War
Trust Economics sees the trade negotiations as a prelude to a new Cold War, with the world divided into two camps: one led by the United States and the other by China. It noted that in the US-UK trade framework agreement, the two countries agreed to strengthen mutual economic security by addressing “un-tradeable policies of third countries.” Although China is not named, it is known for protecting its state-owned enterprises with industrial policies and dumping its excess capacity on the global market.
Ongoing discussions include the scenario of China exchanging its rare earths for American semiconductors and opening up its services sector, particularly banking and investment, to the United States. China has had a near monopoly on rare earths for decades, largely due to predatory practices that have driven foreign companies out of the sector.
The United States has a trade surplus with China in services. Last year, China’s gigantic goods trade surplus of nearly $296 billion with the United States was offset by a services trade deficit of about $33 billion, according to the U.S. Census Bureau.
Beijing is exploring further opening up the services sector as a bargaining chip in its trade negotiations. China’s opening up is a beneficial strategy for Beijing as well, according to Lian. He wrote in his article that greater financial market openness would increase China’s “stickiness” and make it “too big to sanction.”
The tariff battle is expected to escalate into a currency war because the United States has an outsized vulnerability: its nearly $37 trillion debt.
Defending the dollar’s supremacy
Currently, the dollar’s status as the world’s reserve currency and the primary currency used in international trade allows the United States to borrow more at lower interest rates. The level of U.S. debt is now so high that annual interest payments exceed the nation’s defense spending.
In fiscal year 2024, which ended Sept. 30, 2024, the United States spent $882 billion on interest on its debt, compared with $874 billion on defense spending, according to the Treasury Department. That makes the role of the U.S. dollar even more critical, because any devaluation or significant uncertainty about the currency could lead to a default.
China holds $756 billion worth of U.S. Treasuries, according to the Treasury Department, which collects the data through U.S.-based brokers. Hong Kong has an additional $253 billion. But China is the world’s largest holder of U.S. Treasuries—surpassing Japan’s $1.1 trillion—because Beijing is buying undisclosed amounts through European institutions.
An April report by J.P. Morgan Chase said that, contrary to popular belief, “China has not reduced its holdings of U.S. Treasuries; the holdings are simply more covert,” according to a translation of the original Chinese text. So Beijing could potentially sell U.S. Treasuries at a critical time when the market is losing confidence in the dollar and force interest rates to rise if no buyers can absorb China’s “dumping.”
If the dollar’s status as a reserve currency is shaken, it could also lead to a weakening of Washington’s borrowing capacity. The CCP knows this and has been working for years to replace the US dollar with the yuan. In 2015, Beijing launched its own Cross-border Interbank Payment System (CIPS), for transactions in Chinese yuan. While CIPS is not comparable to the US dollar-based global payments system – called the Clearing House Interbank Payment System (CHIPS) – in terms of scale and global reach, it is growing.
The Payment System and the Digital Yuan
Every month, the volume of financial transactions through CIPS is about 700 billion yuan, almost double the amount in 2021, according to the Peterson Institute for International Economics (PIIE). That scale is still insignificant compared to the $1.8 trillion in daily transactions, or more than $50 trillion in monthly transactions, through CHIPS, according to its official website. And CIPS still relies heavily on the U.S.-led SWIFT, or Society for Worldwide Interbank Financial Telecommunication, to send payment messages, according to the PIIE.
The CCP has also noted that the world of digital currencies offers a new arena for competition, and in 2022, China introduced its own digital yuan.
The current situation calls for the United States to find more places outside of China to hold U.S. debt and defend its reserve currency status in both the physical and virtual worlds. He pointed out that a type of cryptocurrency referred to as “stablecoins” is a “creative” answer to the challenge. “Stablecoins can theoretically allow unlimited purchases of U.S. Treasury bonds,” he said. “The sky is the limit.”
Stablecoins are digital money that is pegged to a fiat currency on a one-to-one basis. Issuers guarantee holders that they can convert the money back at any time. Therefore, stablecoins can provide the decentralization and financial efficiency of digital money, combined with the stability of a traditional fiat currency.
So far, 98% of stablecoins are pegged to the dollar, and 80% are issued outside the United States, according to the Atlantic Council, a Washington-based think tank. Holders can bypass banks and even their country’s unreliable currencies. For example, a coffee shop in Argentina or a small business owner in Vietnam can transact in digital currencies that are pegged directly to the dollar. Last year, stablecoin transaction volume reached $27.6 trillion, 7.7% more than the combined transaction volume of Visa and Mastercard, according to cryptocurrency exchange CEX.io.
Holding US Debt and Stablecoins
Stablecoin issuers generate revenue by investing the dollars they receive in exchange for digital tokens, and they have already emerged as significant holders of US debt. They hold more than $120 billion in Treasury bills and are poised to hold more than $1 trillion in Treasury bonds by 2028, according to an April report from the Treasury Department’s Advisory Committee on Debt. That means stablecoin issuers could become the largest holders of Treasury bills, surpassing China and Japan.
Two months ago, Hong Kong passed legislation on stablecoins, although it has yet to issue its own stablecoins. Chinese giants such as Ant Group and JD.com, Inc. have said they will submit applications to become issuers once the legislation goes into effect on August 1, according to Chinese state media. The U.S. Congress on July 17 passed a landmark cryptocurrency bill that establishes a regulatory framework for stablecoin issuers.
The GENIUS Act, signed into law the following day, requires stablecoin issuers to back their digital tokens with either cash or U.S. Treasury bonds. Treasury Secretary Scott Bessent posted on the X platform in June that “stablecoins can enhance the supremacy of the dollar.”
By leveraging stablecoins, the dollar has extended its dominance from the physical to the virtual world and has found more buyers of US debt at a collective level comparable to China and Japan. It’s a brilliant strategy, and time will tell how effective it will be…
