Markets are increasingly shifting focus from monetary to fiscal policy.
Yet the currency impact of fiscal policy is typically more complex. We
set up a simple framework to think about the relationship and apply it
to the G4 currencies.
The FX impact of fiscal easing is most bullish if five conditions are met: (1) negligible “Ricardian equivalence” and a high multiplier allow for a meaningful aggregate demand boost, (2) the central bank tightens policy in response, (3) a growth-oriented, infrastructure-heavy package raises the terminal real rate, (4) credit risk premia remain stable, and (5) the currency is more sensitive to higher real rates than to the associated current account deterioration.
In the US, any
post-election fiscal stimulus will likely be bullish for the dollar by
virtue of allowing the Fed to normalize policy faster and to a higher
terminal rate. A sustainable debt level should prevent a spike in credit
risk or a “Ricardian” response domestically. Capital inflows should
dominate in driving up the dollar even though the current account would
likely deteriorate. A potential tax repatriation holiday would provide
an additional boost.
In Japan, fiscal
easing should remain neutral for the yen. Monetary policy will stay
accommodative, but the demand and growth impact will be limited by
“Ricardian” households. Credit risk premia should prove stable, and
rising debt won’t fuel inflation expectations absent signals of debt
monetization. If demand did rise, the yen would be vulnerable to current
In the Eurozone,
the impact of fiscal easing depends on the national distribution.
Infrastructure spending in core economies or via a centralized programme
could be bullish in permitting the ECB to exit unconventional policy
sooner and lift the terminal real rate without raising the credit risk
premium. The more bearish, if less realistic, scenario is significant
fiscal “slippage” in the indebted periphery, which could lock the ECB
into unconventional policy, lower core rates and trigger renewed
In the UK, the
pound would likely strengthen if Treasury not only slowed down on
fiscal tightening but spent actively on housing and infrastructure.
Neither risks around default or debt monetization nor “Ricardian”
behaviour should come into play. Real rates would likely rise and
dominate the currency impact against any deterioration in the current
account, to which sterling is insensitive.