Reality Bites
Market exuberance about the US growth outlook has pushed up interest rates and the US dollar, as has the stance of US fiscal policy. But can high interest rates and a seemingly overvalued exchange rate be compatible with ‘US exceptionalism’?
If one ever needed confirmation that financial markets price things primarily based on beliefs about the future, this week gave it. Once it became clear that, no, President Trump was not going to enact sweeping tariffs by executive order on Day 1, the ‘Trump trade’ and ‘American exceptionalism’ drivers of pricing reversed somewhat. The US dollar depreciated, bond yields declined and US share prices slipped. The Australian dollar bounced about three-quarters of a cent against the US dollar in the space of a few hours. These moves did not entirely undo the shifts seen since the US election, but they highlighted just how overbought the Trump trade was. People trade the belief, and then reverse course when reality turns out differently. (And then reverse course again on some actual announcements, but that’s another story.)
The deeper question of the future path of US interest rates remains.
Contrary to last year’s recession worries, US economic growth remains well above past assessments of trend. Unemployment remains low and employment growth robust. Inflation has declined but remains sticky above the Federal Reserve’s 2% target. Compared with other major advanced economies, the United States has been remarkably resilient to tight monetary policy. The US economy has powered along almost as if the fed funds rate had not been so high.
This resilience has been a bit of a puzzle. Low fixed-rate mortgages have long been a factor there, so they cannot fully explain this divergence. Macroeconomic statistics being what they are, one can never completely rule out ‘it was all a mirage and will be revised away eventually’ as an explanation. Stronger balance sheets in the wake of the policy support during the pandemic may be contributing. Also relevant, though, is the role of fiscal policy working in the opposite direction to monetary policy. This is a theme we have highlighted previously.
Conventional macro analysis tells you that it’s the change in the fiscal deficit – sometimes called the ‘fiscal impulse’ – that contributes to economic growth. That said, the level of the deficit surely matters for the level of output, and thus any assessment of how demand and supply compare. And at more than 5% of GDP, the US federal deficit is helping to supercharge demand in an already fully employed US economy. By contrast, because burgeoning public spending in Australia is being more or less matched by rising taxation, the boost to the level of overall demand is smaller.
At this scale, differences in fiscal stance can influence the paths of monetary policy interest rates. In broad terms, the narrative for the last couple of years has been that central banks needed to set monetary policy to be restrictive to get inflation back down to target. Once they were reasonably sure that the disinflation was on track, central banks would start cutting interest rates back towards neutral, wherever that was. Because monetary policy works with a lag, this process needs to start before inflation has returned all the way back to target.
The idea that monetary policy needs to become less restrictive as inflation approaches target remains intact. Less clear, though, is whether interest rates need to converge to ‘neutral’ (r* in the economics jargon) in the short term, or to some other rate.
Where policy rates end up troughing in different economies over the next year or so therefore rests on the answer to two questions.
First, how does the (long-run) neutral rate relate to the central bank’s estimates of it?
It has long been our house view that, wherever neutral is, it is higher than it used to be. The Federal Reserve and other central banks have seen the same developments and revised up their estimates of neutral over the past year or so. Based on the ‘dot plot’ of FOMC members’ views on the ‘long-run’ level of rates, the Fed’s estimates of neutral are centred on 3% or a touch below. This is still a little below our own view that this longer-run concept of neutral is likely to be somewhere in the low to mid 3s.
Depending on how quickly central banks pivot their thinking, it is therefore possible that some central banks will need to backtrack as they discover that the neutral rate they were aiming for is actually higher than they thought. This evolution, and the likely policy actions of the Trump administration, underpin our current forecast that the Fed will start raising rates again in 2026. Policymakers never forecast that they will end up backtracking, so the ‘dot plot’ shows a smoother convergence without a turning point. But it’s also plausible that the smoother path implied by the ‘dot plot’ occurs because policymakers revise up their estimate of neutral further.
(We don’t think the RBA is subject to the same risk of upward revision to their estimates of neutral in the near term. Their models already imply that the neutral nominal cash rate is in the mid 3s, and the recently adopted checklist approach to assessing broader monetary conditions will reduce the risk that statistical inertia in those models leads to underestimates of neutral.)
Second, is long-run ‘neutral’ where monetary policy needs to converge to, or is there something (like fiscal policy) that monetary policy will end up needing to lean against to keep inflation at target?
One could argue that this is making a distinction without a difference: those forces are just the things that cause ‘true r*’ to move around. The issue is that the standard models used by central banks to estimate the neutral rate do not include the impetus from fiscal policy or other factors over which monetary policy has no direct influence. The researchers in this field acknowledge that persistent changes in fiscal policy could affect the level of neutral. But because their models omit any fiscal variables, they cannot quantify the effect.
Despite these shortcomings in the models, FOMC members clearly recognise the issue. The ‘dot plot’ shows that they do not expect the fed funds rate to reach ‘neutral’ until after 2027. So even if their view on neutral is still too low, their recognition that other factors lean against a swift return to neutral will help counterbalance this.
Because other major economies have different fiscal (and growth) outlooks, the shifting market view on US rates has implied shifts in views on interest rate differentials, and so exchange rates. But this puts the US dollar even further above levels at which purchasing powers are at parity, an anchor point that exchange rates tend to gravitate towards over a run of years. Most published measures of the real effective US dollar exchange rate show it at levels surpassed only by the mid-1980s era that ended in the Plaza Accord.
Higher interest rates and a seemingly overvalued exchange rate. One can’t help thinking that reality will bite the US exceptionalism narrative sooner or later.
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