Steven Englander of Citi invokes 'String theory' to open the door to multiple universes, and in one of them Paul Krugman is undoubtedly Fed Chairman. Since the EUR is so dormant in this universe it may be interesting to expand our Strategy efforts to other, possibly more interesting, ones.
Start with the assumption that a Paul Krugman Fed would advocate strong fiscal and monetary measures and tolerate a significant run-up in inflation. At the end of the note I attach some links and some quotes which support this Krugman Fed view.
The question is how the USD would respond in this world. The first instinct is to say that the USD would be a lot weaker and that would undoubtedly be the first market reaction. There is enough suspicion about the US fiscal and monetary policy framework that additional fiscal and monetary easing combined with higher inflation are unlikely to allay.
Now consider some of the options – again multiple universes are helpful. The question is whether the ‘no holds bar’ stimulus measures could succeed in reducing unemployment. The Krugman view is that in the presence of excess capacity, fiscal policy is both justified and effective. He argues that it is effective unconditionally and especially if the Fed is accommodating the fiscal stimulus.
The case for higher inflation is more controversial. Krugman makes the case that higher inflation would erode debt burdens, basically forcing haircuts on creditors. So the needed balance sheet adjustment and reduction in real debt burdens would be accomplished quickly. And if the headwinds that the US economy faces is related to these balance sheet issues, full employment could be achieved and growth would be restored to trend.
My presumption is that the Krugman Fed would cooperate by financing the fiscal expansion, allowing government spending or (or in a very strange Republican Krugman parallel universe) tax cuts to have a real impact without affecting government debt. He makes a strong distinction between pumping liquidity into the banking system and directly into the real economy. In conventional terms, this is Financial Repression 101, but inflation is desired, achieved and beneficial.
As a footnote there is an interesting parallel with Keynes’ 1930s argument that higher inflation was then needed to reduce real wages uniformly and efficiently. To a first approximation all workers take the same inflation hit. Efficiency is achieved because worker-by-worker negotiation is avoided. A similar argument can be made with respect to the current need for creditor haircuts and the issues with one-by-one debt write-downs.
As a second footnote, the difference between Krugman Fed inflation and 1970s stagflation is that the Krugman inflation would have a real effect by reducing the real debt burdens, whereas the 1970s inflation in retrospect was doomed to fail because policymakers were trying to hit an employment target that was unachievable without constantly accelerating inflation.
The Krugman Fed (or maybe its successor Plosser Fed) would presumably revert to a lower inflation path once real debt burdens were cut, and full employment and trend growth achieved. The low inflation path would be credible once the benefits from higher inflation disappeared. Put another way, what is needed is not permanently higher inflation, but a one-off step-up in wages and home prices relative to debt burdens, so the burdens can be more easily serviced. Once this is accomplished, inflation can return to a low level.
There are two downsides here. One is that the policies might not succeed. Plenty of economies have tried to spend and print their way to prosperity and the track record is not encouraging. In fact, if it worked, everyone would do it. The argument in its favor is that real debt reduction would help resolve some of the headwinds facing the US economy.
The second negative is the Fed loss of credibility. Even if the Fed were able to convince investors that they would head back to the 2% inflation target, behavior might change because households, governments, corporations – in fact, everyone but savers – would come to see the Fed as the Tooth Fairy who fixes all wrongs. Savers might demand permanently higher real rates on the view that inflation haircuts had been permanently added to the policy arsenal.
As Krugman points out there is a cost to an extended period of long-term unemployment. The bottom line is that unless you make low inflation a canonical virtue, you have to compare the long-term losses from lower credibility (if they exist) against the long-term gains from moving to full employment quicker (if they exist).
We took a long detour but now arrive at FX. The potential Krugman Fed outcomes are:
1) Full court press fiscal and monetary policies succeed, we get back to full employment and the Fed regains its virtue and shifts back to low inflation.
In this case we would see the USD as having a sharp and immediate real and nominal depreciation. This may be viewed as desirable by the Krugman Fed (who would suggest to other central banks with sluggish economies that they similarly inflate if they don’t like the currency outcome.) If the central bank is telling fixed income investors that they will face a significant haircut, foreign investors will likely impose a sharp cut in the price of US assets via the exchange rate.
However, if the policy succeeds, it means that eventually US policy rates can be normalized relatively quickly. So the acute depreciation could eventually be followed by a USD rebound, especially if other countries were still facing headwinds that their policies had not addressed. It is probably the case that real USD would be stronger in real terms and weaker in nominal terms, but USD in a full-employment, normalized real rate environment would be a very attractive asset.
A major downside risk is that the initial USD depreciation generates a round of global capital controls that disrupt both economies and financial markets.
2) Same as 1) but high inflation is stickier and becomes a permanent or semi-permanent factor.
Same as 1) but the USD rebound is less pronounced (and possibly nonexistent) in nominal terms, as the ongoing inflation discourages both domestic and foreign investment. Long-term higher inflation will probably be a negative for growth, so there would be an additional risk premium on both nominal and real USD.
3) The policies fail - Weimar Republic
We can contrast with the potential USD outcomes from the current policy regime:
1) Low inflation, stagnant growth and constant debate on whether additional the banking system will be forcefed additional reserves.
Continued battle between chronic risk of additional stimulus and the headwinds faced by other economies. Foreign investors would prefer to sell USD in this environment because they see little exit from easy money and easy fiscal policies (a very dampened version of their reaction to the Krugman Fed) but are conscious of the tail risk associated with the EUR and the sensitivity of EM to the global business cycle. So we cycle between episodes of USD buying on safe haven concerns, and selling when risk appetite is restored.
2) A Bernanke Fed that succeeds in gradually returning to full employment.
Virtue rewarded. The USD rallies sharply in nominal and real terms as soon as there is any realistic prospect that the Fed will pursue its exit strategy and fiscal imbalances contract.
We leave it to you to weight the probabilities of these outcomes.
Links to recent Paul Krugman posts and selected quotes.
“higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea.”
“would a rise in inflation to 3 percent or even 4 percent be a terrible thing? On the contrary, it would almost surely help the economy.”
“Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need”
“And now the results are in: Keynesians have been completely right, Austerians utterly wrong — at vast human cost.”