Impacts of the right policy mix on USD

U.S monetary policy won’t be tight enough to produce an optimal combination for USD strength.

Fiscal and monetary policies have been put through the wringer by coronavirus, particularly fiscal policy. As a symmetric global shock, it’s understandable that policy has moved in the same direction for all countries. However, there has been some divergence and this looks set to grow. It leads us to ask which countries have the best policy mix going forward for currency strength.

As with many things in economics, the best policy mix for currency strength is a contentious issue. If you talk to the Bundesbank, for instance, officials will claim that tight fiscal and monetary policy is the key to currency strength as debt and inflation fears are kept down. The fact that Germany presided over many years of deutschemark strength before the Economic and Monetary Union (EMU) began in 1999 seems testament to this policy prescription. But others might argue that a loose fiscal policy and tight monetary policy is better as the loose fiscal policy helps the economy perform strongly while tight monetary conditions bear down on inflation. The surge in USD in the 1980s during the Reagan/Volcker era would seem to support this case. However, right now, most countries seem to have loose fiscal policy, given high deficit/GDP ratios and loose monetary policy as judged by the plethora of negative real rates. But in Standard Bank’s view, within this, there is some divergence, and divergence that could weigh on USD.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said, there are a couple of reasons for this view. On the fiscal front, the White House continues to push hard on the side of fiscal spending with the USD1.2tr infrastructure bill to be paired with a likely bill for “soft” infrastructure spending that President Biden will hope to push through the evenly-divided Senate via reconciliation. In contrast, other countries around the world are not looking at extending fiscal easing much further. Of course, the Biden administration hopes to make some of this back with tax increases but that could be hard to push through given the divided Senate.

The recently released Biden budget still anticipates U.S deficit/GDP ratio to be over 5% of GDP for some years. That’s down the estimated 16.7% of GDP this year, but still high in historical terms. What’s more, it’s based on assumptions of broadly full employment, suggesting little room here to squeeze out more tax revenue, and with very low bond yields, with 10-year treasuries not assumed to be above 2% until 2024. Get this assumption wrong and the fiscal dynamics could get a lot worse. That’s certainly a danger when you look at the other side of the policy coin; monetary policy.

While we would rule out the idea that the Fed feels duty-bound to keep policy rates down in order not to spoil the fiscal arithmetic, there’s still the fact that the bank has adjusted its policy strategy so that the level of policy rates over the next few years are likely to be lower than those that would have prevailed under the old strategy. In other words, there’s a danger here that the fiscal position will remain relatively loose (notwithstanding the improvement in the budget that will come about the recovery in growth and the labour market) and monetary policy won’t be tight enough to produce an optimal combination for USD strength.

“If policy is too out of kilter, creating fears of both a debt explosion on one side and rampant inflation on the other, USD really would be toast. But even if the absence of such extreme outcomes (which we doubt anyway), the policy mix in the US still seems conducive to a weaker dollar. And, policymakers’ perspective that’s probably not a bad thing. For while fiscal and monetary policy are the two big arms of policy, currency policy can have a role too. Of course, the US does not pursue an active currency policy unlike some other countries, but policymakers may be aware that loose fiscal conditions can bring pressure to bear on the current account – as we are seeing right now – and that in turn implies that a weak dollar may not just be the outcome of this policy mix, but also a desirable outcome”, Mr. Steve Barrow said.