Beware the politics of deficits and trade

GROWING US fiscal deficits could not only accelerate the pace of interest rate hikes, but also generate turmoil where they intersect with the politics of trade. Even as we shift away from the age of easy money, central bank decision-making will rightly continue to hold the market's attention.

But there is a pernicious policy feedback loop that could hold nasty surprises for investors. Monetary policy does not operate in a vacuum, and in the wake of the latest budget decisions in the United States, there is growing recognition that the resulting, massive buildup in US fiscal deficits could accelerate the pace of interest rate hikes. Less acknowledged is the potential turmoil those fiscal deficits could cause when they intersect with the politics of trade.

As fiscal deficits widen in the mature part of an economic cycle, additional fiscal stimulus cannot be absorbed by excess slack in the domestic economy. As a result, the stimulus is exported through higher import demand. Furthermore, fiscal expansion at this stage also leads to inflationary pressures, pushing monetary authorities to raise interest rates to combat inflation, thereby boosting the purchasing power of the home currency. The end result is usually higher trade deficits. In a different era, this economic linkage would be the end of the story.