Is the US Dollar Still Too Strong? A Mid-Term Outlook
The question of whether the US dollar is “too strong” or “overvalued” continues to be a central topic in macroeconomic discussions, particularly given the current environment of heightened uncertainty and divergent monetary policies. This analysis examines the medium-term outlook for the dollar – a horizon of two to five years – moving beyond simple nominal exchange rates to consider broader economic indicators.
Beyond EUR/USD: The Real Effective Exchange Rate (REER)
Economists typically assess currency valuation using the real effective exchange rate (REER), rather than focusing solely on bilateral rates like EUR/USD. The REER combines the dollar’s exchange rate against a basket of major trading partner currencies, weighted by trade flows, and adjusts for inflation differentials. This “real” component is crucial; a stable nominal exchange rate can still represent real appreciation if domestic inflation exceeds that of trading partners, thereby diminishing international price competitiveness.
Current Dollar Strength: A Historical Perspective
According to the Federal Reserve’s Real Broad Dollar Index, the dollar remains historically strong in real trade-weighted terms, even though it has retreated from its peak in early 2025. The European Central Bank data from March 13, 2026, shows EUR 1 = USD 1.1476. Similarly, the BIS real broad REER for the US remains above recent norms. While the dollar has corrected since the highs of 2024-2025, it remains significantly elevated in real effective terms.
The International Monetary Fund (IMF) reported in February 2026 that the US external position was “slightly weaker” in 2025 than warranted by medium-term fundamentals and desirable policies, suggesting continued pressure for a real weakening of the dollar as part of a gradual external correction.
The Twin Deficits and US Debt
Medium-term risks to the dollar are closely tied to the “twin deficits” – a high budget deficit and a current account deficit. The IMF noted the federal budget deficit fell to 5.9% of GDP in fiscal year 2025 but is projected to exceed 6% again, with the debt ratio expected to continue rising. The current account deficit reached $226 billion in the third quarter of 2025, equivalent to 2.9% of GDP. This reliance on foreign financing of US consumption and investment creates structural vulnerabilities.
A shift in global investor demand away from US financial assets – due to factors like narrowing interest rate differentials or increased political risk – could trigger a “macro” adjustment involving a weaker dollar and an improved trade balance.
Negative Net International Investment Position (NIIP)
The US Bureau of Economic Analysis reported a net international investment position of -$27.6 trillion at the end of the third quarter of 2025, a record low, representing -89% of nominal GDP. While the US boasts deep and liquid financial markets, this negative NIIP significantly increases the dollar’s sensitivity to changes in foreign investor appetite for US assets.
De-Dollarization: A Gradual Trend
De-dollarization, while not yet dramatic, is a long-term trend characterized by central banks diversifying foreign exchange reserves and a growing share of international transactions conducted in currencies other than the dollar. This gradual shift, combined with the US twin deficits and rising foreign debt, could reduce foreign interest in US assets.
Political and Institutional Risks
Political and institutional risks, particularly concerning the independence of the Federal Reserve, are gaining prominence. The IMF emphasized the Fed’s credibility as a “highly valuable asset” that must be protected through independent monetary policy decisions. Perceived political pressure on the Fed could increase the risk premium on US financial assets, potentially weakening the dollar, especially given its already overvalued state according to REER metrics.
A Balanced Outlook: Gradual Real Correction Expected
The overall picture is balanced but consistent: the US dollar remains overvalued in real effective terms, although it has partially corrected from its 2024-2025 peak. Several factors point towards a gradual real correction, including the twin deficits, record negative NIIP, gradual de-dollarization, and rising political/institutional risk premiums.
While short-term dollar strength is possible, particularly during global shocks, the combination of external imbalances and an expensive REER is likely to create sustained downward pressure on the dollar in the medium to long term.