Financial markets have been obsessed by monetary policy – US rate cuts or Eurozone easing. But with many countries’ rates close to or below zero and central banks already holding large sums of government debt, there is little room to loosen monetary policy to stabilise growth and generate inflation. And there are political concerns if monetary loosening leads to currency weakness.

Monetary policy may be running out of road. Fiscal policy easing is thus increasingly on the agenda.

The US administration’s fiscal stimulus boosted growth and inflation expectations, with the Federal Reserve hiking rates in response. This loose fiscal policy with tight monetary policy strengthened the dollar as economic theory would expect.

But with the Fed now cutting rates, currency markets seem willing to accept both fiscal and monetary policy being loose.

Four current scenarios illustrate the changing relationship. We’ve labelled them the Standard, the Stalemate, the Substitute and The Slippery.

  • The Standard. The cyclical positives of US tax cuts offset the structural risks of a higher budget deficit and government debt, so loose fiscal policy accompanied by tight monetary policy led to dollar strength.
  • The Stalemate. Warsaw this year announced a 40bn zloty ($10bn) stimulus comprising increased spending and lower taxes – not unlike the US example. However, whereas the Fed raised rates, Poland’s central bank expects no change until at least 2022. The outcome has been only marginally positive for the zloty.
  • The Substitute. The US and Polish stimuli coincided with relatively strong growth, but Australia’s fiscal stimulus this year came as growth slowed. The central bank appeared to prefer that to measures such as QE. The fiscal stimulus is thus a substitute for further monetary easing and the Australian dollar can withstand further bad economic news because that raises the probability of more fiscal aid. So this too is mildly currency positive.
  • The Slippery. By contrast, a loose fiscal policy accompanied by loose monetary policy should have a negative currency impact. It is often the start of a slippery slope as higher inflation and foreign bond sales weaken the currency, economic imbalances emerge, and monetary-policy independence is jeopardised.

However, the traditional relationship appears to be breaking down, with currencies withstanding these loose-loose policies.

South Africa’s fiscal position has loosened markedly for three years as poor growth limits revenues and increases expenditure. But although the central bank is now cutting rates, the rand has performed strongly with bond yields falling, despite increased borrowing.

Historically, markets would push yields higher and weaken the currency. But this year the rand has been immune because of low inflation (high inflation erodes currency and bond values), low yields (falling global rates are outweighing local factors), and a belief that central banks anywhere could be buyer of last resort for government debt.

Investors thus seem willing to give currencies more leeway. Yet economic gravity must ultimately prevail with a loose-loose policy: either inflation will return or imbalances widen, with potentially very challenging currency consequences.

However, while these external conditions remain in place it can be hard to identify a catalyst that would cause these slippery currencies to weaken suddenly, despite growing structural concerns.

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