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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Mr Trump's new man may want a strong dollar, but the President's policies may not allow it .....

March 16, 2018

 

ref :- "King Dollar Is Really Just a Grand Duke", James Mackintosh, Markets / Streetwise in the Wall Street Journal

Of all the unprecedented features of the current US administration, the fantastically high turnover of personnel in key positions must rank as about the most extraordinary. The rumour mill has already moved onto the position of National Security Adviser Lt. Gen. H. R. McMaster and we haven't even had a chance to mention Larry Kudlow, the new Chief Economic Adviser to President Trump. Mr Kudlow has replaced Gary Cohn, who you may remember was forced to resign after failing to convince the President of the dangers of protectionist trade policies in general and slapping tariffs on imported steel and aluminium in particular.

Ironically, Mr Kudlow is no great fan of tariffs either but has avoided upsetting his new boss by suggesting that limited and targeted tariffs can make for appropriate policy  --  and we can safely assume that he had China in mind. But the main conclusion to draw from Mr Kudlow's first interview since his appointment was that his espousal of a Strong Dollar policy remains firmly intact : "A great country needs a strong currency".

Mr Trump and Mr Kudrow go way back but if that sounds like a typically Trumpian line it doesn't necessarily reflect either the present reality or the possible ramifications of current policies. To judge the state of a nation purely on the strength of its currency is deeply flawed, but if you're looking at things in that light then the USA is merely "middling" along. It's current value  --  measured against trading partners and adjusted for inflation  --  is pretty much bang in line with its average since President Nixon abandoned the gold standard in 1971.

And of course since Mr Trump was elected in November 2016, the Dollar Index has fallen by 14%. Plainly, the currency hasn't been doing "great", even for those who would argue that the country is. But much of the move can be ascribed to the recovery of previously struggling economies outside of the US, and the relative positions of the US and its competitors in the economic cycle. The cycle of growth in the US is already well-advanced, whereas elsewhere (in the Eurozone, for example) the cycle and its knock-on effects for monetary policy are only just getting going. That being the case, the weaker dollar is not a reflection of weakness in the US economy and not something that Americans should worry about unduly.

They might start to worry though if the dollar falls much further, and unfortunately for Mr Kudlow the WSJ argues that Mr Trump's policies could almost have been designed to force it lower. Putting aside Mr Trump's protectionism and unfortunate handling of the US' allies for a moment, the problems for the dollar centre around two main areas : tax cuts that will have to be financed by increases in government debt, and the idea (assumption, even) that the economy can be goosed without doing the same for inflation. Mr Kudlow's comment "Just let it rip, for heaven's sake" suggests that he has little worry in that regard, but others may feel that such a gung-ho attitude in someone in his position carries significant dangers.

The tax cuts are problematic for the dollar in two ways : 

1. They add fiscal stimulus at a time when the economy is already running at close to full capacity, which is likely to prove inflationary without being able to promote real growth. Inflation requires a weaker dollar to keep international prices unchanged.

2. Increased deficits that the tax cuts will require means issuing more government debt, much of which will have to be bought by foreigners. To attract those buyers will require higher interest rates  --  which would offset the stimulative effects of the tax cuts  --  and a weaker dollar.

Now, there are of course counter-arguments to all this. Mr Kudlow, being a supply-sider and fitting perfectly into the line taken by the White House, believes that the tax cuts will be self-financing. In other words, the income from the stronger growth engendered by the cuts would make up for any income lost by a smaller tax take. Well, that didn't work for Ronald Reagan in the 1980's when it had more chance of succeeding (because it came earlier in the cycle), and it's hard to see it making up the extra $1.4 trillion now. The "Laffer Curve" theory of the relationship between tax rates and government income still has plenty of proponents, but frankly evidence in it's support is scanty.

The idea that "letting growth rip" will not send inflation soaring would have been much easier to dismiss in the past, but even those who believe it will come sooner or later would have to concede that at the very least the dynamics that drive rates of inflation have changed. It's undeniable that things like changing demographics and the effects of automation on productivity have lessened inflationary pressure in a very fundamental way, but Mr Mackintosh believes that ultimately tightness in labour markets and the pressure for higher wages will eventually result in inflation. It's a view that we can go along with, even if old-style rampant inflation in developed economies may well be a thing of the past.

Given the potential difficulties in store for the greenback, Mr Kudrow may want to tone down the strong dollar rhetoric in case it comes back to haunt him. It'll be interesting to see if his long relationship with the President stands him in good stead if the going gets tough ..... mind you, if job security was high on Mr Kudlow's agenda, presumably he wouldn't have gone to work in the White House in the first place.

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