The dollar’s appreciation may represent the U.S. economy’s biggest speed bump in 2017, and that could be good or bad, depending on whether President-elect Donald Trump follows through on measures aimed at accelerating growth.
The Bloomberg Dollar Spot Index, which tracks the greenback against 10 global currencies, has gained 5.7 percent since the Nov. 8 election, largely on expectations for lower taxes, higher government spending and looser regulations under Trump. All these could goose growth and pose questions for the Federal Reserve.
The potential for stimulus comes with unemployment already at a post-recession low of 4.6 percent and inflation creeping closer to the Fed’s 2 percent target. Even without fully factoring in Trump’s fiscal plans, central bank officials in December raised the number of rate hikes they foresee in 2017, from two to three, as they signaled greater confidence in the economy. Chair Janet Yellen even warned members of Congress on Nov. 17 that new fiscal stimulus could have “inflationary consequences” that the Fed would have to take into account.
In that environment, a strengthening dollar will help the Fed keep the economy from overheating by dampening exports and inflation should Trump deliver on his growth-boosting agenda. If, however, the Trump bump never quite happens, or takes longer to make itself felt in economic activity, the dollar’s appreciation could prove premature and problematic.
“The market is priced for perfection in the U.S. next year,” said Lee Ferridge, senior macro strategist at State Street Corp. in Boston, referring to the dollar’s recent spike. “If parts of the fiscal policy get delayed or watered down, or don’t have the growth impact that everyone seems to expect, it could be that growth next year ends up lower because of the impact of the dollar and the impact of higher rates.”
To be sure, part of the dollar’s appreciation reflects the international outlook. Economists surveyed by Bloomberg expect growth in gross domestic product in the U.S. to reach 2.2 percent in 2017. That compares to 1.4 percent forecast for the euro zone and 1 percent in Japan.
Higher growth and correspondingly higher interest rates relative to other large economies create more dollar demand as foreign companies expand in the U.S. and investors buy dollar-denominated securities. As the dollar gains, that hurts growth by making U.S. exports less competitive and suppresses inflation by making imports cheaper.
Typically, the currency headwind has a marginal impact against the greater gains of a growing overall economy. But the dollar’s recent swing is big enough put a real crimp on growth.
In a July 2015 blog post, Mary Amiti and Tyler Bodine-Smith, economists at the New York Fed, estimated that a 10 percent appreciation of the dollar within a quarter would drag down growth over one year by 0.5 percentage point, assuming the stronger exchange rate persisted. Including appreciation before the election, the dollar has strengthened 7.1 percent in the fourth quarter, the largest gain in a quarter since 2008.
Ferridge noted that economic growth is already at historically weak levels.
“GDP growth was just 1.7 percent in the third quarter year-on-year,” he said. “If you’re taking half a percentage point off that because of the dollar, that’s meaningful.”
The dollar could, of course, quickly weaken if Trump does not or cannot deliver fiscal stimulus, or other policies for boosting growth. Congress controls the purse strings and while his Republican party commands both chambers, some of its members may be reluctant to back measures that boost the U.S. deficit. As a result, it could take much of 2017 for the policy outlook to clear, and every month at current dollar levels will take a toll.
“You’re getting some tightening in financial conditions now, but if fiscal stimulus is not delivered you might just get the downside of financial conditions without the upside,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.
That makes life more complicated for the Fed. It forces them to consider not only the upside risk to growth and inflation should fiscal stimulus arrive in force, but a downside risk in the event it does not.
“If nothing happens in the fiscal territory the Fed will be more cautious, and the three rate hikes probably won’t happen,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington. “It’ll be more like one or two.”
On the other side of the equation, if Trump does push through measures that succeed in perking up growth, Perli said he’s not that worried the Fed will have to speed up to prevent overheating.
“You have to take into account the global outlook,” he said. “Global growth will not be exuberant and that’s going to filter back to the U.S. and calm things down a little bit.”
That’s a sentiment that Fed officials appear already to have in mind. Fed Governor Jerome Powell, speaking in Indianapolis in late November, discussed the challenges of raising rates when growth and inflation around the world are so low.
“You can really export demand through the mechanism of your exchange rate if you’re the only one raising rates,” he said. “It just urges caution.”