05/09/2019 - Dollar strength may be challenged by fiscal policy

President Trump is pressuring the Federal Reserve to ease aggressively and has complained that China and Europe are taking unfair currency advantage. And, in early August, Washington designated China a currency manipulator. The ever lower and flatter American yield curve, however, signals concern that monetary easing will struggle to revive the economy. Further evidence hereof resides in the coinciding strength of the US dollar and Gold.

Dollar coin

Frustrated by the central bank, the President has already hinted that he may have to take matters into his own hands and deliver a new fiscal boost, and this despite an already very large public debt pile. Even several mainstream economists are urging more fiscal easing to fight the next downturn, arguing that the exceptionally low level of interest rates not only questions the effectiveness of further monetary policy stimulus in isolation but also affords more fiscal space.

Proponents of Modern Monetary Theory (MMT) take the argument a step further, making the point that since the government and the central bank ultimately share the same balance sheet, the mainstream fixation on the level of government debt is misplaced as the government can simply finance fiscal expansion through the central bank balance sheet, either through a direct overdraft or through central bank purchases of government bonds and is, as such, not forced to raise funds through either taxes and/or debt issuance.

The traditional policy constraints of crowding out through higher interest rates or Ricardian equivalence, as consumers trim spending in anticipation of higher future taxes, are thus neatly removed, leaving fiscal expansion free to lift demand until the economy returns to full capacity and inflationary pressures reappear. At that time, the theory argues, governments can simply cut back on spending or increase taxes, and/or central banks can simply tighten credit conditions by draining liquidity. History shows that there are several real-world caveats to this logic, but let’s continue the thought experiment and zoom in on the less frequently discussed currency channel.

Assume, for the sake of example, that America embarks upon a significant fiscal stimulus combined with monetary policy expansion such that the Federal Reserve, at least initially, fully offsets the traditional crowding out effects on domestic interest rates in nominal terms. In real terms, however, domestic interest rates should decline in anticipation of higher future inflation. Such a policy would, most likely, result in dollar depreciation.

While a weaker dollar would mark a headwind to foreign exporters, stronger American demand from the fiscal boost should at least partly offset this. Moreover, a weaker dollar would bring respite to foreign holders of dollar debt, of which the BIS estimate there is $11.8 trillion outstanding. It is worth recalling, that in the early part of this decade, several emerging market economies fretted that the then aggressive monetary easing of advanced economies was endangering financial stability, as they became the recipients of significant liquidity inflows, and in some cases set capital controls in response.

As the global downturn deepens, the debate on fiscal policy is likely to intensify. For a small open economy, launching an aggressive fiscal policy expansion through its central bank’s balance sheet, seems a less viable option given the resulting squeeze on domestic demand and potential stress on its balance of payments. The initiative of aggressive fiscal stimulus, supported by monetary policy is thus set to be the prerogative of the larger economies with reserve currency status. It seems likely that the United States would lead the way down such a path, while the euro area, for its part, would lag leading safe-have investors to prefer the euro.

Back in 2008, the euro peaked at nearly 1.60 against the dollar as the Federal Reserve eased more aggressively than the European Central Bank. This time, the dice are more likely to be cast by the relative fiscal easing.

Michala Marcussen, Societe Generale’s Group Chief Economist