2017 Isn’t 1981
October 30, 2017
The dollar famously soared in the early 1980s on a mix of tighter monetary policy and a stimulative fiscal policy driven by sharp U.S. tax reduction. Such a policy configuration is falling into place as 2017 winds down, and market sentiment towards the dollar seems to be improving judging by momentum behind published forecasts. Moreover, U.S. economic growth has accelerated to a 3% pace in the middle two quarters of 2017. In contrast, a deepening recession was experienced in 1981 that cast some doubt on whether monetary restraint would be sustained politically.
Because of several additional differences between current times and the early 1980s, one should be careful about assuming that it’s a slam dunk that the dollar will climb broadly over the rest of this year and well into 2018. Foremost, the path of U.S. inflation is still surprisingly low. Measured by the core personal consumption price deflator, it was at 1.3% in August-September, down from 1.5% in March-June and thus still undershooting the Fed’s target by a meaningful margin. From 1.3%, there’s scant room for inflation to fall, and while odds favor an upward shift looking ahead, a big jump in price pressure seems doubtful. Gradualism has been an operative word of the Fed’s forward guidance, and that’s unlikely to be scrapped under new leadership at the Board.
Inflation in the early 1980s plunged in contrast, and that development, even more than the mix of monetary and fiscal policy changes, probably exerted the single greatest boost to the dollar. Inflation fell around 3.5 percentage points in the first 12 months of the Reagan presidency and by 4.7 percentage points in the second year of his stewardship. This drop-off far exceeded expectations and magnified the rise in U.S. interest rates through mid-1982 both absolutely and relative to rates in other economies.
The attitude of U.S. federal government officials toward dollar strength was also radically different from now back then. The Reagan people at the Treasury Department loved the dollar’s advance and interpreted such as market vindication for the appropriateness of its policies. The 1970s had been an activist decade for U.S. foreign exchange market intervention, but that presence disappeared during the first Reagan term. The Trump administration, in contrast, is keenly hostile to the continuing U.S. trade deficit. It’s hard to imagine a deepening deficit juxtaposed against an ever-appreciating dollar being tolerated without policy counter-measures to weaken the currency.
Global markets are now more interdependent, meaning that long-term interest rates tend to move in a more synchronized fashion. Since the end of the first quarter of 2017, the 10-year German bund has declined 8 basis point, and 10-year U.S. Treasury and Japanese JGB yields are virtually unchanged on balance.
The U.S. role in geopolitics has changed enormously. Reagan proudly accepted the challenges and opportunities of being the leader of the free world, especially in protecting Western Europe from any Soviet military threat. In the long run, currency hegemony in national reserve asset portfolios and as a favored transactions currency in trade and for financial investments is likely to rest as much on geopolitical matters and the reliability of a government’s legal system as on sound economic fundamentals. With that in mind, the populist anti-trade and anti-immigrant lurch seen in the United States, although hardly unique as one looks elsewhere around the world, seems inconsistent with the view of some that the dollar is positioned for extended and extensive advance from current levels.
Compared to levels at the end of the first quarter, the dollar in fact is still around 8% weaker against the euro and 5% softer relative to the yen. It is almost 2% stronger against sterling, however, even though the British 10-year gilt yield is about 20 basis points higher now than then. The U.K. is also gripped by a wave of populism. Besides, Brexit poses a singular threat to the British economic performance in the future, the existential danger from Trumpism is more global than U.S.-centric.
The meteoric rise of China as an economic, trade, and geopolitical forces also differentiates these times from the early 1980s. The extent to which China and other economies like the EU are able to capitalize on the opportunity afforded by Washington’s America First doctrine and become leaders in new 21st century industries may create headwinds that limit the dollar’s upside potential.
Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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