For the next 5 days we feature extracts from our macro-economist Bob Gay’s latest piece ‘Policy Blunders and Currencies’
In December 2015, I wrote a commentary entitled “The Illusion of Policy Divergence” which expressed my concerns on the longevity of the so-called ‘reflation trade’ that was in fashion at the time. The consensus of opinion was that US monetary and fiscal policies were poised to diverge from those of the rest of the world because the Federal Reserve had embarked on a pre-programmed exodus from quantitative easing and zero interest rates, while President Trump was promising to undertake a major fiscal stimulus with a massive infrastructure program. That policy mix – tighter monetary conditions and loose fiscal policy – tends to be a classic prescription for currency appreciation, at least as long as it generates a domestic economic cycle that is asynchronous with what is happening elsewhere. Therein lay the illusion: the large parts of the world, notably Europe and China, already were recovering from the lull of 2013 without the need of fiscal assistance. Moreover, other members of the QE Club were destined to follow in the Fed’s footsteps in unwinding their unsustainable asset purchases and negative real interest rates. That scenario meant the global economy as well as national economic policies were gravitating toward convergence rather than divergence, thereby undermining the flimsy rationale for the US dollar rally.
Now that scenario is playing out but under much different initial conditions than those of 2015. Indeed, every major economy is expanding, monetary policies of developed countries are slowly but surely reverting toward a new normal, and most developed countries have turned on the fiscal spigots. Those synchronous policies and economic cycles should promote tranquil exchange rates. Yet something sinister is lurking in the policy climate – namely, the prospect of trade wars and other retaliatory acts, unsustainable debt and deficits, and random acts of nationalism – that could have lasting and damaging consequences. Currencies and asset prices in general will be among the casualties of these policy blunders, and the US dollar in particular may not arise from the wreckage.
To read the commentary 'The Illusion of Policy Divergence' click here.