US Economy In a Sweet Spot. But How High Can USD Go?

February 13, 2024

Elias Haddad

“Goldilocks found a porridge that was neither too hot nor too cold, we've got an economy that's hot where you want it to be hot, like in GDP growth, and cold, where you want it to be cold, on inflation”

- Paul Krugman on why the US economy is even better than the Goldilocks outcome

As good as it gets

The US economy is expanding at a solid pace, the labour market remains tight, and inflation has eased notably over the past year. US real GDP growth in the fourth quarter of 2023 came in at an annualised rate of 3.3% (3.1% for 2023 as a whole), driven largely by strong consumer spending activity. Going forward, leading indicators like the ISM services and consumer sentiment index point to an encouraging growth outlook.

Moreover, the unemployment rate has been below 4% the past two years. According to research by Fed Governor Christopher Waller, the vacancy rate (which stood at 5.4% in December 2023) would need to fall under 4.5% to see a significant increase in the unemployment rate.

Meanwhile, annual personal consumption expenditure (PCE) and core PCE inflation are near two-year lows at 2.6% and 2.9%, respectively. Core inflation is hovering close to 2% on a six and three-month annualised rate of change basis.

Mid-90s or mid-2010s redux

Two periods stand out with a similar favourable macroeconomic backdrop of strong growth and easing inflation: 1995-2000 and 2014-2015. Between 1995 and 2000 annual real economic growth and the PCE deflator averaged 4% and 1.8%, respectively. Between 2014 and 2015 annual real economic growth and the PCE deflator averaged around 2.8% and 0.8%, respectively.

Digging deeper, the mid-90s American boom was characterized by: accelerated employment growth (non-farm payrolls gains averaged 230k per month), rising productivity underpinned by the internet revolution (nonfarm business sector output per hour averaged 2.7%/qtr), solid real disposable annual income growth averaging 4%, as well as robust average annual private consumption and non-residential investment growth of 4.3% and 10%, respectively. The details of the 2014/15 growth period were also good, albeit less remarkable than in the mid-90s especially when it came to productivity as output per hour averaged only 0.7%/qtr.

This time around the US productivity landscape is more comparable to the roaring mid-90s. Nonfarm business sector output per hour increased 3.2% over Q4 2023 to be up 2.7% on an annual basis. In the medium term, artificial intelligence could boost workers’ productivity and lead to low inflationary economic growth if the US manage to harness the potential of artificial intelligence like it did with the internet in the 90s.

USD upside contained

The 1995-2000 and 2014-2015 periods coincided with a sharp appreciation in USD reflecting cyclical growth divergences, different trajectories for monetary policies among the systemically important economies, and a portfolio shift towards US dollar assets.

Similar conditions are present today. The US economy is outperforming most major economies and long-term interest rate differentials (in real and nominal terms) favour a firmer USD. However, we don’t expect USD to make new cyclical highs because a portfolio re-allocation to US dollar assets is not in the cards.

The increase in the supply of safe assets and the risk of US financial sanctions, such as those imposed on Russia, continue to favour active portfolio diversification by central bank reserve managers away from dollar assets. In fact, there has been a steady erosion in the dollar’s dominance in international reserves. The dollar accounted for 59% of official foreign exchange reserves in the third quarter of 2023, down from a high of 73% in 2001. The decline in the dollar’s share of central bank reserves is mostly due to the shift into the Australian dollar, Canadian dollar, and other currencies namely the Korean won, Singapore dollar and Swedish krona.

In addition, the US monetary and fiscal mix is not supportive of sustained USD strength. Historically, the most bullish combination for a currency is restrictive monetary and expansionary fiscal policy. Indeed, the powerful USD rally in 2022 coincided with the start of the Fed’s tightening cycle and expectation of pro-cyclical US fiscal policy (President Biden’s Inflation Reduction Act and the CHIPS and Science Act). The 2016 USD uptrend was grounded on similar foundations as anticipation of looser US fiscal policy (President Trump’s tax cuts) raised the likelihood of more aggressive fed funds rate hikes. The backdrop is different now. The FOMC projects to slash the target range for the fed funds rate by 175bps over the next two years while the IMF forecasts US fiscal policy to modestly detract from growth.

Bottom line

The favourable US macroeconomic outlook bodes well for USD over the next three to six months. But headwinds from reserve managers ongoing portfolio diversification away from dollar assets and the neutral US monetary/fiscal mix suggest the cyclical upswing in the USD index (DXY) will top-out around 110.00.

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