The expansionary fiscal policy of the American government alongside the Federal Reserve's tighter monetary policy should theoretically be appreciating the dollar – yet the currency remains weak. Joachim Fels from the investment company PIMCO attempts to offer an explanation.

Why has the dollar been so weak on the Forex market for so long? This is the question the chief economist at the Californian investment company PIMCO, Joachim Fels, poses in an interesting analysis. According to several widespread theories on exchange rate development, the dollar should really be strong. For one, Fels points to the different development seen in the money produced by the central banks: While the Fed is reducing its bond inventories and, as a result, the money it produces as well, conversely the European Central Bank and the Bank of Japan are continuing to buy bonds. Following this theory, the dollar should be appreciating against the euro and the yen – and not depreciating.

Another explanation suggests that the combination of its expansionary fiscal policy – the tax cuts in the United States should go hand in hand with a growth in new borrowing – and the Fed's tighter monetary policy should encourage the dollar's appreciation. This was the case in the U.S. at the beginning of the 80s when Ronald Reagan's expansionary fiscal policy, in conjunction with Paul Volcker's tighter monetary policy, engendered a very strong appreciation in the value of the American currency. But even this explanatory model seems to fall short in unraveling the current situation.

Growing Inflation Expectations Among Market Players

"Of course exchange rates are often, and not just for short periods, influenced more by passing trends than by underlying economic developments,"* Fels acknowledges; nevertheless, he regards the search for a rational explanation of the dollar's recent weakness as being an important issue to unpick. He offers an explanation: "Perhaps the Forex market is anticipating another, perhaps somewhat veiled, coordination of American fiscal and monetary policy, which the government is using above all to finance a growing amount of new borrowing by issuing bonds with short-term maturities, along with the Fed adjusting their monetary policy by only slowly raising their short-term interest rates if the inflation rate should grow higher than they desire it. In doing so, they keep the returns on short-dated government bonds low."*

Fels admits that a new cooperation such as this is still merely speculation. But the markets are actually behaving as if pre-empting this scenario. The growing equity prices also fit with this conjecture of a higher inflation rate, so, too, the gradually increasing inflation expectations of market players. The unusually small gap between the returns on long and short-dated government bonds could also be explained by this theory of an above-average increase in the short-term for American national debt.

*Editor’s Note: Though accurately translated, these quotes could not be sourced.