Between the fiscal stimulus, the Fed, and the tax cuts (which are, of course, a big source of the stimulus), the global supply of dollars is getting squeezed, which is, according to various reports, pressuring some emerging market economies (EMs). How seriously should we take this and what might its impact be on the US economy? To telegraph my conclusion, I suspect these developments will lead to higher US interest rates and a stronger dollar than would otherwise occur. The stronger dollar, in tandem with the fiscal stimulus, could put upward pressure on the trade deficit, even with all the tariffs intended to push the other way. Neither derails the recovery, but they are risks.
There’s been a number of recent articles worrying about the impact of “dollar il-liquidity” in EMs. We’ve got the Fed raising rates and reducing its balance sheet, both of which reduce the supply of dollars. But we also have the tax cut bill in play. Because this beast is deficit-financed to the tune of $2 trillion over 10 years, with deficits this year and next of ~5% of GDP, the US Treasury has had to kick up its debt issuance to fund the damn thing.
Then there’s the repatriation of corporate dollars from abroad. According to this AM’s FT:
“US companies repatriating profits drained more dollars from global markets in the first quarter of the year than did the Federal Reserve’s actions to shrink its balance sheet, according to data that suggests embattled emerging markets cannot simply blame the Fed for their plight.”
So, there’s a diminished global supply of $’s and more of the currency is flowing into the Treasury to make up the difference between Federal revenues and outlays. These dynamics push up interest rates and the value of the dollar, the latter of which raises the cost of debt service in countries with dollar-denominated debt, including EMs, large and small.
Economist Brad Setser wrote about the problem, noting that the chair of India’s central bank, “rather remarkably—even called on the U.S. Federal Reserve to slow the pace of its quantitative tightening to give emerging economies a bit of a break. (He could have equally called on the Administration to change its fiscal policy so as to reduce issuance, but the Fed is presumably a softer target.)”
I won’t belabor this, as it’s all very speculative, but while rising rates and the stronger dollar will put pressure on some EMs (not all–see Setser), US monetary and fiscal policies are not the only, or even the main, drivers of capital flows in and out of their countries. This was the point of a recent, tight speech by Fed Chair Powell, featuring figures like those below showing a) there’s no obvious, negative correlation between the Fed’s policy rate and EM cap flows (you don’t see flows go down as the policy rate goes up), and b) there’s a much better fit between relative EM growth rates and flows (AE=advanced economies).
There’s just a lot of moving parts that determine exchange rates, capital flows, and financial market conditions. Powell notes, for example, “that although the Fed has raised its target interest rate six times since December 2015 and has begun to shrink its balance sheet, overall U.S. domestic financial conditions have gotten looser, in part due to improving global conditions and central bank policy abroad.”
That said, Powell fails to deal at all with the recent, cyclically-weird U.S. fiscal expansion, which, as the FT quote above suggests, is playing a significant role in sucking up global dollars. So, I think there’s a case to be made that our fiscal and monetary policies are creating some global stress, but I’d also submit that this is all the highly expected, and–again, except for the dumb tax cut–thoroughly telegraphed outcome of policy “normalization” and the re-pricing of riskier assets relative to safer ones.
If some EMs are stressed by dollar il-liquidity, how does that redound to us? Dollar-denominated EM debt is not particularly inflated, and, as GS economist David Mericle points out [no link], “the largest EM dollar borrowers now tend to be exporters and commodity producers whose revenues are largely dollar denominated too, reducing the risk of currency mismatch” (i.e., they’re somewhat insulated from the stronger dollar). Simply put, EM conditions deserve to be on the watch list, but there doesn’t seem to be too much US contagion risk.
The more likely pressure stems from the US trade imbalance. The strengthening dollar, the capital inflows from EMs seeking safer and higher yielding US debt, and the stimulus at our close-to-full-employment conditions all put upward pressure on the trade deficit, even with the Trumpian tariffs in play. A higher trade deficit isn’t a macro-problem right now (though even at strong demand, it means fewer factory jobs; it effects the composition of jobs, not the number), but if there’s a shock out there, that imbalance could worsen the damage.
Not to mention how much it will piss off the President.