US Policy Mix Reconsidered

In our understanding of foreign exchange determinants, we attribute a privileged role for the policy mix–the combination of monetary and fiscal policy.  The best policy mix for a currency is when monetary policy is tightening, and fiscal policy is loosening.  

Notable examples include the Reagan-Volcker dollar rally of the early 1980s and the German policy mix when the Berlin Wall fell.  The Deutschmark rally proved to be too great of a stain on the ERM narrow bands and out of that crisis, the Maastricht Treaty for EMU was born.  

That is the policy mix in the US.  We had anticipated that policy mix regardless of the outcome of the 2016 election as both leading candidates promised fiscal stimulus.  Still, under President Trump, the fiscal stimulus–a combination of tax cuts and spending increases–have been greater than expected.  

The policy mix has not peaked.  Indeed, another tax cut bill was introduced yesterday by House Republicans.  They hope to pass it before the November election.  Last year’s tax cuts for individuals was to expire in at the end of 2025, in order to allow for passage with a simple majority.  Now the legislators have come back to make them permanent.  

Also, the cap on the deduction for state and local taxes was retained, much to the chagrin of Republican officials in high-tax states.   The bill will also preserve the increased tax credit for dependents and the roughly $22 mln estate tax exemption for couples (doubled last year).  The lower threshold for medical expense deductions (7.5% rather than 10%) will be extended for two more years (through 2020).  There are also some measures that make it easier for small businesses to offer 401k plans, as well as introduce new savings accounts for education and newborns.  

The full impact of last year’s tax cuts and spending increases are still working their way through the economy.  The Congressional Budget Office estimates that 11 months into the fiscal year, the US has recorded an $895 bln federal deficit.  This is a $222 bln increase from the same year-ago period.  With GDP likely near 3% this year, the deficit will be near 4% of GDP, but the risk is that as the economic growth moderates the deficit will rise toward 5% of GDP by 2020.  

Meanwhile, it is clear that the Fed is not done normalizing monetary policy.  A hike later this month has long been discounted.  Investors are feeling more confident about a rate hike in December to0.  The CME’s model shows nearly an 80% chance has been discounted in the fed funds futures strip.  

What about next year?  The Fed will begin holding monthly press conferences, which as we have argued is important to increase the central bank’s room to maneuver.  It makes all meetings live, though officials have indicated there is no need to accelerate the gradual pace.   The market appears to be pricing in a little more than a 50% chance that the fed funds target will be 2.50%-2.75% by the end of Q1 19.   There is only a 30% chance that the target is 2.75%-3.0% by the middle of next year.  

The tighter monetary policy and looser fiscal policy looks set to continue for at least the next six months and possibly somewhat longer.  The ECB has indicated it will not raise rates for another year.  Fiscal policy may ease slightly next year, especially in Spain and Italy, and it may not be as tight in Germany.  Japan’s monetary policy is still near open-throttle, and in October 2019, the sales tax is scheduled to be hiked.  However, the Abe government has suggested some fiscal offsets to the tightening.  


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