Coming back to today, we’ve not seen such a big dollar surge but could we see a huge fall in the future?

In the past, a loose fiscal/tight monetary combination has produced enormous dollar strength, followed by enormous losses. Could the same happen this time?

By most measures it looks as if the US has played fast and loose with fiscal policy in recent years and there seems little hope of significant consolidation in the future. It was not just the handouts during Covid but other policies such as the USD1tr infrastructure plan and the near USD900bn Inflation Reduction Act that have poured fiscal gasoline onto the fire of US growth.

As a result, it is hard to argue that alleged US exceptionalism is anything other than growth bought by injudicious fiscal largesse. The deficit for the fiscal year that just finished was up nearly a quarter from the prior year at USD1.7tr; the largest outside the Covid years. Future projections are not much better as things like rising interest costs and slower workforce growth are seen lifting the debt ratio from around 100% of GDP now to 180% in 2053 by the nonpartisan Congressional Budget Office.

Such projections might not cause alarm if we thought that politicians will get their act together to reduce the deficit; but that seems a faint hope. Of course, there’s also the possibility that much stronger growth will come to the rescue but we should not forget that these huge deficits are occurring in spite of the fact that the economy is already at full employment.

In other words, much stronger growth over time will likely have to come from people working harder and/or more efficiently and while there’s a lot of hope that AI can do this, we’ve heard things before about supposedly miraculous inventions, like the computer or the internet that have singularly failed to produce any such bonus.

Importantly, other G10 countries have not been lured into this fiscal alchemy and hence US policy appears very loose relative to others. At the same, or even because of this, monetary policy is relatively tight. The Fed has hiked rates by a good deal more than most central banks and while some seem to have stopped, notably the ECB, it seems as if the Fed could hike again.

Even if it does not the ‘higher for longer’ mantra definitely seems to be the preserve of the Fed, not any other G10 central bank. This relatively loose fiscal and tight monetary combination should be a force for currency strength, at least initially. For it lifts yields more than others and draws in capital. That’s what we appear to have seen although it is always difficult to disentangle the effects of other influences, such as safe-asset demand. Have we seen a similar policy combination in the past that led to currency strength, specifically the dollar?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the answer is ‘yes’ and it was the last time that inflation really soared in the 1970s and early 80s. A combination of aggressive Fed tightening under Chair Volker combined with determined fiscal easing by the Reagan administration in the early 1980s created this same loose fiscal and tight monetary mix. It was something that seemingly contributed to a huge near 50% rally in the dollar over a four year period; clearly much more than we’ve seen in the past year, or so, even though the same policy combination has been in place. But interestingly, this strength gave way to a subsequent fall that was much more than 50% and economists ascribed it to the fact that the policy combination created a huge current account deficit that ultimately drew the dollar in. It was also caused by central bank intervention to weaken the dollar which included the Fed.

Coming back to today, we’ve not seen such a big dollar surge but could we see a huge fall in the future? In Mr. Steve Barrow’s view, it seems unlikely given that these days current account movements appear to be far less influential as FX turnover is completely dominated by financial flows, not trade flows. And secondly, he sees no real prospect of US intervention to weaken the dollar even if it gets considerably stronger. He does see longer-term weakness in the dollar of the order of 10-20%, but not the 50%-plus we saw back in the second half of the 1980s.