Thinking

Fed Independence, Trump Reflation, and the Primacy of the Dollar

This is part of an ongoing conversation with Adam Tooze.

There is a tension at the heart of US political economy. President Trump wants to reindustrialize America and create jobs for US workers. To that end, he has promised both big tax cuts and a huge investment program. A big fiscal shock is coming.

He has also attacked US’ trade partners for suppressing their currencies. He wants the dollar to weaken against the euro, the yen and the yuan, so that US manufacturers can compete in global product markets.

The problem is that deficit spending at home is expected to accelerate inflation, which would prompt to the Fed to hike faster, which in turn would strengthen the dollar. As part of the Trump reflation trade, the dollar has already strengthened in anticipation.

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Dollar Index. Source: Bloomberg.

There are only two possible scenarios that could allow the Trump White House to square the circle. The first scenario is one where both the US macroeconomy and the Fed oblige. That is, US inflation could fail to accelerate despite the fiscal shock and the Fed could hold fire waiting to see the whites of inflation’s eyes. The first component wouldn’t be altogether surprising given that US inflation is driven not by domestic slack but by global slack. But given what we know about the Fed’s reaction function, the second—a dovish, patient Fed—is quite unlikely.

The second scenario is one where the Fed’s independence is compromised by Washington. With the resignation of Daniel Tarullo, Trump can now appoint three of the seven governors of the Fed immediately. (Monetary policy is decided not by the Board but by the FOMC which consists of the seven on the Board and five regional Fed presidents, always including the president of the New York Fed.) Yellen’s term also ends on Feb 3, 2018; at which point Trump could replace her with a lackey. In short, it is not inconceivable to see the Fed revert back to control by political masters.

The second scenario is not as likely as it appears either—despite the clear interest of the Trump White House and the opportunity to pack the Fed with Trump appointees. This is because the Senate has to confirm the appointments. While the Senate Republicans are not as crazy about Ayn Rand as those in the House, it is hard to see them falling behind a policy of packing the Fed with doves. In other words, the balance of power in Congress points in the opposite direction as the White House. If Trump succeeds in this endeavor, it would likely be with the support of Democrats in the Senate. And they would demand their own pound of flesh.

There is another reason to doubt the reflationary scenario. The Fed’s independence—secured by Volcker’s coup in 1979—has served the interests of  Wall Street well. Since the Trump administration is packed with Goldmanites, it is difficult to see them supporting an attack on the Fed’s independence. To be more precise, it is not clear that the big banking firms would pursue their long-term interests (and resist attacks on the Fed’s independence) or their short term interests (which would be well served by the steep yield curve attending a Trump reflation).

A related issue is that of financial deregulation. It is amply clear that the Trump White House and the Republican Congress are going to unshackle Wall Street. This solves at least one problem while risking another. The former is the global shortage of safe assets. Deregulation of Wall Street banks would allow them to expand balance sheet capacity and intermediate dollars to lend offshore via FX swaps. The latter is the risk of financial stability. As Tooze notes, unshackling dealer balance sheets may unleash a new, unsustainable credit boom.

There is of course an entirely different possibility suggested by McHenry’s letter to Yellen and more generally, the strength of the Ayn Rand fanatics in Congress. Namely: Congressional hawks could prevail in the battle for political control over the Fed and make it even more hawkish and its reaction function more formulaic by law (by demanding say that the Fed justify deviations from the Taylor Rule). That would doom any possibility of a great boom in real activity.

Tooze’s original discussion centered not on the political economy of the Federal Reserve per se but the impact of Trump’s economic nationalism on the dollar’s role as the hard currency of choice globally. Tooze mentions three areas of conflict:

 (1) [T]he tension between the dollar’s reserve role and the desire of the Trump administration to boost exports by increasing American “competitiveness” and talking down the dollar; (2) tensions around global bank regulation; (3) nationalist backlash from Trumpites in Congress against the role of the Fed as a global liquidity supplier, by way principally of the swap lines.

As for (1), it is not clear that dollar strength is a required to sustain the dollar’s role as the reserve currency. The dollar has been both stronger and weaker than it is now (or is expected to be) without compromising the willingness of other central banks to hold US dollars.

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It is even less clear how (2) could work against the dollar’s preeminence. If US banking firms are subjected to less onerous regulations then the dollar’s share of international funding—already at 75 percent—would tend to increase with the balance sheet capacity of US banking firms.

A nationalist backlash against the Fed’s international activities as envisioned by (3) could potentially backfire on the dollar. In particular, if the Fed is forced to close down it’s swap lines the other hard currency issuing central banks would look for alternatives, which could result in solutions that undermine the dollar’s position. For instance, they could denominate their settlements in euros—a scenario that would be consistent with a major unraveling of the transatlantic alliance.

The Policy Tensor contends that the real threat to the dollar’s hegemony is the possibility of a global trade war which would usher in a more nationalized and a more regionalized world. A global trade war between the United States and China, not the victory of Marine Le Pen, is the most important political risk to financial markets of 2017.

The dollar’s role is due to a mutually-reinforcing combination of America’s command of the global maritime commons, the liquidity of US dollar funding markets, the depth of US capital markets, the network externalities of currency denomination (for invoicing and payments), the stability and predictability of US institutions, and the sheer weight of the United States in the world economy. It is mighty hard, even for an administration led by Donald Trump, to undermine the dollar’s role in the global monetary, financial and economic system. The closest competitor is the euro. And for the euro to merely bid for the dollar’s role in the world economy would take dramatic changes in the political economy of Europe and an outright breakdown of the Western alliance. We may possibly be headed in that direction but we are nowhere close to that scenario.

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