One of the toughest calls over the last six months has been guessing which of President Donald Trump’s many campaign pledges would be implemented once his administration came into power, and more to the point if they would live up to the rhetoric on the campaign trail.
Apart from diehard supporters, most commentators expected pledges to be watered-down when Trump got into power and have since been surprised at the vigor with which he has continued to pursue many of those objectives. Now, vigor is one thing, impact is another. His moves on healthcare were largely blocked by Congress but some other policies may gain greater support and Adam Posen, President of the Peterson Institute for International Economics is quoted in the Telegraph as saying, in the Institute’s estimation, the market is seriously underestimating the consequences of some of his more likely polices. In particular he is concerned about Trump’s fiscal stimulus coinciding with a tightening by the Federal Reserve causing a severe spike in the U.S. dollar.
Whether Pozen is right or wrong only time will tell, but for any business with involvement in imports or exports somewhere in their supply chain a significant strengthening of the U.S. dollar could have a significant impact.
“The Fed is going to be far more aggressive than people think. Our view is that there will be three to four more rate rises this year,” Pozen is quoted as saying.
The institute’s primary concern is about the consequences for emerging market debt of Fed tightening. Pozen said the resulting drain on dollar liquidity from the international financial system would have profound consequences after the surge in dollar-denominated debt over the last decade. Our concern here is more about the other implication of rising U.S. Federal Reserve rates and the impact they would have on the exchange rate.
The promise of rising rates has caused the dollar to spike in the past as markets have anticipated rate rises, but Pozen believes investors have become inured to Fed guidance and are discounting the probability of rate rises this year. Yet the economy continues to grow steadily. Employment is high — the U.S. economy is near full employment, and inflation is picking up. If President Trump comes through on his promises rates rises are inevitable, which brings onto the second issue, radical tax cuts combined with fiscal stimulus would cause U.S. federal borrowing to rise.
Quoting from the article, Posen believes there is enough Republican support for corporate tax rate to fall from 35% to 25%, along with income tax cuts for the wealthy and the middle class, and more generous tax deductions for business. Such a policy at this late stage of the business cycle will cause the economy to overheat, forcing the Fed to jam on the monetary brakes, which would send the dollar through roof. The institute suggests this could result in a 15% spike in the dollar hitting exports and undermining domestic manufacturers at the mercy of import substitution.
There is the possibility that Pozen has this all wrong. It’s not a forgone conclusion that President Trump will achieve his tax cuts, although an increasingly hawkish Fed is already in evidence. But at the very least, the situation deserves monitoring with the awareness that such a combination could have a very detrimental impact on the dollar and potentially for firms trading internationally. Posen is a former rate-setter on Britain’s Monetary Policy Committee, and is known for his work with former Fed chief Ben Bernanke on Japan’s Lost Decade and inflation targeting, he has sufficient experience and credentials to make his warnings worth listening to.