The Reagan Deficits, Growth, Long-term Yields, Inflation & the Exchange Rate. Implications for today?

The tax cut signed in December and the two-year budget deal passed on February 9, which served to focus attention on trillion dollar deficits, have affected markets.

According to one analyst, reflecting the conventional wisdom:

What if you ask the man on the street? Say you were one of those local news programs and left your air-conditioned office and went out on the street and interviewed people randomly, and asked them: “Why is it bad when we run big deficits?

I assure you that not one person would be able to answer your question.

The answer, of course, is: it makes interest rates go up.

Is that so? Maybe not. Go back to the Reagan years. Initially, during the 1981-82 recession, the deficit increased to 6% of GDP. With the recession over and output rising strongly, the deficit remained high (4%-5% of GDP) and never went below 3%.

The long-term Treasury yield went lower throughout the period. So did inflation.

The dollar appreciated significantly against major currencies. That was reversed in 1985 with the “Plaza Accord”, an agreement between the governments of France, West Germany, Japan, the US and UK to depreciate the dollar in relation to the Deutsche Mark and Japanese yen by intervening in currency markets.

Forward to the present.

Following the signing of the tax cut in December 2017, long-term yields have gone up together with rising inflation expectations and falling dollar. The budget deal depreciated the dollar, increased inflation expectations and the 10-yr yield.

Growth has been tepid since the end of the 2007-09 recession, while inflation has remained “too low”. Is this combo about to change? Given the Fed´s “tightening stance”, that´s very unlikely. Downside risks are significant, which could bring a reversal in the inflation expectations and yield trend. A weak economy could contribute to keeping the dollar down.


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