The Morning Commentary: The Effects of Fiscal Policy on Exchange Rates: It’s Complicated
A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
The Effects of Fiscal Policy on Exchange Rates: It’s Complicated
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Andrew Kositkun Foreign Exchange Head Trader
The result of the U.S. presidential election remains uncertain as markets continue to wait on a handful of states to finish counting their outstanding ballots. While margins are razor thin, Joe Biden appears to have a wider path than Donald Trump but, again, uncertainty is very high.
Regardless of who wins the White House and controls Congress, a key market expectation is for additional fiscal support. But what is the exact impact of fiscal stimulus? To understand this, one has to first understand the assumptions behind the projected effects.
In a demand-side world, fiscal stimulus should raise household income, which, in turn, should lead to more spending and create a positive feedback loop. GDP is expected to increase by more than the amount of injected stimulus, as the fiscal multiple is greater than one. Moreover, the multiplier for government spending should be higher than the multiplier for taxes. This is because government spending is assumed to have a direct or first-order impact on GDP, whereas taxes will matter in an indirect way through household disposable income. Further, the fiscal multiplier is assumed to be lower in an open economy versus a closed one, as the increase in income is “leaked out” through a worsened trade balance.
The issue is that these conclusions are based on assumptions that are not always true. Some of these key assumptions are as follows:
Households are not forward looking and are dismissive of any dynamic considerations, such as whether fiscal measures are temporary or permanent. If households consider that government spending today will have to be repaid via higher taxes in the future, then the conclusions on spending could change significantly.
The marginal propensity to consume (MPC), or how much of each additional dollar a consumer spends, is assumed to be constant across consumers, income level, age and time. Clearly this isn’t true as high-earning households, and credit-constrained ones have different propensities to spend any extra income. A similar dynamic holds true on the other variables as well.
Interest rates are assumed fixed. But doing this assumes that monetary policy is absent. Fiscal stimulus should put upward pressure on inflation, which, in turn, pushes up nominal and real interest rates. This rise in rates risks crowding out private investment. As a result, the more accommodative the monetary stance, the more effective fiscal policy becomes. This logic would advocate for fiscal stimulus when monetary policy is constrained by the zero lower bound.
So what does all this net out to? All else being equal, higher spending and lower taxes should lead to FX appreciation, but conclusions are context specific. While there is a difference in impact between spending and taxes, this distinction isn’t granular enough. The type of spending (tax or deficit financed) and the type of taxes (corporate or income) utilized also matter. To this point, it isn’t a surprise that empirical evidence on fiscal policy’s impact on FX is mixed.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
Equity markets around the world continue to rally, with U.S. markets opening sharply higher once again. It appears that markets are looking through the risk of civil unrest and contentious legal challenges. While things are still in early innings, a divided government implies no tax hikes, which is good for equities, and a lower chance of increased regulatory constraints, which is good for big tech. Conversely, the chances for massive fiscal stimulus is materially lower, which is negative for growth but does lessen longer-term debt-level concerns.
On stimulus, Senate Majority Leader Mitch McConnell said passing a stimulus bill is a top priority during the lame duck session. House Speaker Nancy Pelosi finds herself in a weaker position now than before the election. With less negotiating leverage, any possible stimulus package amount likely moves closer to McConnell’s skinny bill ($500 billion) than the White House offer of $1.8 trillion.
U.S. initial jobless claims came in at 751,000 against expectations for a 735,000 reading. This disappointing result, relative to expectations, follows up on yesterday’s disappointing ADP report and continues to show a labor market under pressure and in need of stimulus. The government’s jobs report will be published tomorrow.
The Bank of England kept its policy rate unchanged at 0.1% in a unanimous vote. The bank also increased its asset purchases by 150 billion pounds, which was higher than consensus expectations. The British pound finds itself higher on the session, as markets look through easing in a similar manner to how markets looked through Reserve Bank of Australia easing earlier in the week. On the fiscal side, Chancellor Rishi Sunak extended furlough payments of 80% of wages to employees of shuttered companies until the end of March.
Eurozone retail sales came in soft, with the headline number falling 2.0% month over month versus expectations for a 1.5% decline. This data series should only get worse as lockdowns increase.
The Norges Bank left rates unchanged at 0.0% as expected, with the bank forecasting that rates will remain at current levels for the next couple of years. The krone is higher on official comments, suggesting concern over the currency’s weakness, which is partially due to weak oil prices.
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