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COMMENTARY: Notes from US: Fiscal-monetary tussle

We spent the past week travelling through the US and interacting with a wide range of policy makers, from the Fed to the White House, and private sector participants, from thinktanks to financial sector. We lay out below eight key takeaways, all under the overarching shadow of tense geopolitics and ballooning debt burden.

AI and the economy

Everyone found the promise of AI tantalizing, but expectations of its near-term impact on inflation, productivity, jobs, and financial markets were highly uncertain and varied. Firms are spending a lot of money on procuring AI services, but the impact on that investment on their earnings was yet to be clear. AI service producers and hardware manufacturers are enjoying a revenue windfall and low cost of funding for infrastructure buildout, but their sustainability will depend on the direction of interest rates, financial market sentiment, and likely disruption from open-source models. Meanwhile, public sentiment on AI has soured, with large tech companies being seen in poor light, nationwide backlash against datacentre buildout, and widespread cybersecurity risks. Large debt issuance by AI companies could lead to an economywide rise in interest rates, pushing up credit risk, while near-term inflationary impact from surging demand for electronics and construction material is worrisome.

The dollar

Several officials in the Trump administration continue to hold the mercantilist view that a weak dollar is necessary to bring back manufacturing and boost export competitiveness. At the same time, there is nervousness about wholesale selling of USD assets, especially US treasuries. Heightened inflation risks and expectations of short-term rates remaining high also get in the way of a weak dollar narrative. Nonetheless, wars and aggressive use of sanctions on those using USD payment rails have made many actors want to reduce their USD exposure and invoicing for trade and commerce. 

International relations

The US is antagonising ostensible allies and foes alike, with the recent breakdown in Canada-US trade negotiations and subsequent spike in mutual tariff rates the latest illustration. Ramping up of sanctions on Iran could put China-US relationship under stress, and US-Europe relationship is fraught over trade and security matters. Considerations such as inflation or mid-term election prospects don’t appear to deter President Trump from pursuing his policies, which is putting the Republican party in a bind. Recent announcement of US oil firms taking stakes in Venezuela is unlikely to have an immediate impact on energy prices.

Midterms

Both the House of Representatives and the Senate are at play for Democratic takeovers this November. President Trump’s exceptionally low approval ratings, especially about economic management, have made many races competitive. The Democrats have several constraints, including unfavourable jerrymandering of many districts at the House races, internal conflict between the centrists and progressives, and lack of reliability of polling figures, but overall, the momentum is still with them.

Fed and monetary policy

Fed Chair Warsh gave a widely followed speech at Jackson Hole last Friday, where he tried to course correct from his earlier communications that had left the market unsure about the Fed’s direction. He asserted that (i) monetary and financial conditions were not tight, (ii) inflation has missed the target for way too long and remains too high, (iii) the Fed had more work to do to ensure price stability, (iv) policymakers must be confident that underlying inflation is moving clearly toward the target and at sufficient speed. We don’t think the September Fed meeting outcome is a done deal though, as price, wage, and jobs data between now and then would influence Warsh considerably.

Fiscal dominance

Warsh’s Jackson Hole speech was notable for its omission of fiscal indiscipline getting in the way of the Fed’s price stability mandate. Treasury Secretary Bessent’s interventions in recent weeks, from yen intervention to increasing bond buybacks, reveal a distinct unease with elevated long-term rates. This however runs counter to Warsh’s desire to receive unfiltered signals from markets. The chance of fiscal risk turning into financial risk is rising as the deficit, debt, and associated interest payments keep rising. The US Treasury has been increasingly issuing debt at the short end of the duration spectrum, but that could prove to be problematic if Warsh’s Fed becomes keen to hike short-term rates.

Additionally, we did not hear from anyone about a scenario in which trade tensions and tariffs are brought down. Given that they can bring in at least 1% of GDP in revenues, tariffs have become a pivotal component of keeping the fiscal deficit in some check. On the major spending items like pension, healthcare, and defence, there seems hardly any commitment toward spending rationalisation.

Market risks

Elevated equity market valuations reflect optimism about AI-driven productivity and earnings growth. This is a big bet, with equity risk premium turning negative as stock yield has fallen below safe asset returns. Just because recent slippages in fiscal or spike in equity prices have not led to major equity market correction does not mean the market is invulnerable.

Past episodes of large infrastructure boom around disruptive technology are instructive. Those episodes were typically characterised by overshooting investment and financial markets, and each ended with financial market crash and recession. The reason for this is that when there is widespread optimism, many companies push up spending, but only some end up making money. If cost of capital rises, if datacentre projects face delayed completion, if the public resist AI rollout, the financial market repercussions could be substantial. An equity market adjustment does not have to cause a systemic crisis through. The dotcom bust was not the cause of a severe recession, although the value destruction was substantial.

Middle powers

With the tussle with Canada to the fore, US observers were rethinking the middle power arguments made by Canadian PM Carney earlier this year. Middle powers worry about access to critical imports, payments systems, cloud infrastructure, while leaning on trade. The great power rivalry of the past decade has eroded trust and made finding ways to build common understanding among middle powers critical. But few countries have come to the side of the Canadians, with EU and UK taking their time in forming a unified strategy. A collective pushback against Washington seems unlikely.

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