Although in office less than a fortnight, the new US Administration is showing a disregard not only for the domestic convention but international agreements like migration and the US dollar. Some had argued that the conduct of monetary policy was tantamount to currency manipulation, but the G7 and G20 offered a more nuanced understanding.
Manipulation itself was not frowned upon because it violated the sanctity of the markets as some moralists argue. Rather, manipulating domestic interest rates was accepted. It is not a zero-sum game. Currency manipulation to boost exports is a zero-sum undertaking and is thought best to avoid.
Over the last couple of weeks, several Administration officials have talked about the dollar. Some of the remarks came in confirmation hearings and need to be kept in that context. However, others seem to have gone out of their way to comment. Trump himself warned a few days before the inauguration about a too strong dollar.
Today, the head of Trump's new National Trade Council, Peter Navarro, told the Financial Times that the euro was "grossly undervalued." He warned that the euro was like an "implicit German mark" and its low valuation gave Germany an advantage over its trading partners. Navarro said Germany was one of the main obstacles to a trade deal with the EU. He confirmed what has been suspected: TTIP, the Transatlantic Trade and Investment Partnership negotiations, will not be going forward under Trump.
On balance, Trump officials have expressed concern about the strength of the dollar or, as Navarro complained, about other currencies being undervalued. The OECD confirms. Its models see the euro at nearly 25% undervalued, sterling almost 16.5% undervalued and the yen 11% under-valued. The Mexican peso, whose marked depreciation has been exacerbated by comments from Trump, is undervalued, according to the OECD, by 147%.
On the other hand, Ted Malloch, who is widely thought to be the next US ambassador to the EU -- he's presently a professor at Henley Business School at the University of Reading -- is a Eurosceptic. He said he wanted to short the euro and intimated that the Eurozone could collapse in the next 18 months.
It is still early days for the Trump Administration and it is not clear whose opinion will carry the day. Trump, for example, seemed to support torture to acquire information but deferred to his Secretary of Defense, General Mattis. It is not known whether the comments are one-off or part of a sustained campaign.
At the same time, we believe that the dollar is strong not because European, Japanese and Mexican officials want a weak currency, though some clearly do, but because of the incentive structure created by actual policy. In particular, the divergence of monetary policy, broadly understood, has arguably been the single-biggest force lifting the US dollar.
There is some anticipation of a more supportive policy mix. Fiscal policy has been neutral to a drag in recent years, but it has been clear since last summer that regardless of the election outcome, US fiscal policy would be more accommodative. That policy mix of looser fiscal and tighter monetary policy is associated with currency appreciation. Looser fiscal policy includes tax cuts (reform), infrastructure spending and some supply-side deregulation. Alone, such fiscal efforts would likely be understood by investors as favorable for the dollar.
Looser fiscal and tighter monetary policy was the policy mix under Reagan-Volcker that led to a dramatic dollar overshoot in the early 1980s and was the first dollar rally since the breakdown of Bretton Woods in 1971. It was also the policy mix in Germany when the Berlin Wall fell. The fiscal laxity needed to finance the leveraged buyout of East Germany was offset by the tightening of monetary policy by the Bundesbank. The Deutschemark overshoot that resulted spurred an ERM crisis that ultimately paved the way for monetary union.
Another consideration has joined the mix. The border tax adjustment is seen by many as automatically spurring a significant dollar appreciation. It is part of a destination-based corporate tax that is being touted. It would tax imports and exempt exports. Relying on theory, many economists expect that the dollar would rise to offset the tax. A 20% tax would produce a 25% appreciation of the dollar.
That view is based on economic identities that are true by definition. If the dollar does not appreciate in full, then the domestic savings must increase and/or domestic investment must fall, with the rest of the world moving equally but in the opposite direction. We are skeptical that a change in goods prices will automatically drive the dollar. In our understanding of foreign-exchange drivers, we put an emphasis on the market for capital rather than the market for goods.
We can understand how a tax on imports can boost the price of goods, which could, in turn, increase the general price level (inflation). Yet higher import prices could also sap the purchasing power of US households and weaken aggregate demand. We can envision how a tax on imports and exemption for exports can boost some sectors' profitability and boost corporate savings.
Jawboning can impact foreign-exchange prices, as we saw Tuesday, with the pop in the euro following Navarro's comments. However, over time, we expect policy is the ultimate driver of exchange rates. Although details about the new Administration's fiscal policy are not known, we anticipate a bullish mix and other policies that are broadly supportive of the dollar. The jawboning will likely soon reach a point of diminishing returns as has the jousting with Mexico and Japan..
It is possible that to offset the strong dollar policy, President Trump could order an intervention in the foreign-exchange market. Since 2008-2009, many observers, media and some policymakers have argued that the US (and others) are engaged in currency wars. We demurred. If the US were to intervene to drive the dollar lower, it would make a mockery of the earlier cries.
Policymakers did not recall the lesson of the Great Depression, thereby weakening the financial landscape before the financial crisis. Policymakers did not recall the lessons of the 1920s about the disparity of income and wealth and the political blowback that could result. Policymakers did not recall the limits of a country's willingness and ability to service foreign debt from current production. Policymakers may be forgetting the disastrous consequences of protectionism (taxing imports and exempting exports) and beggar-thy-neighbor currency policies.