Dollar Performance When Big U.S. Tax Cuts Are Undertaken

November 13, 2017

It remains unclear whether President Trump will get a tax cut law to sign by the end of this year or even in 2018. Both the Republican-controlled congress and he want to get this done, but the devil is in the details. If this legislation indeed happens, it will undoubtedly be large in scale like the tax cuts during the administrations of Ronald Reagan and George W. Bush. These two precedents provide some insight into what might be expected to happen to the dollar and other key U.S. economic variables.

One commonality found in each of the earlier tax cut experiments is that the federal deficit, contrary to the prediction of their designers, widened sharply as a percent of GDP. And one notable difference between those episodes is that they were enacted at very different stages of the business cycle. The Reagan cuts were phased in between 1981 and 1983, a period almost entirely characterized by a deep recession. As a counter-cyclical policy tool, they were appropriately timed. In contrast, the Bush43 cuts, initiated in 2001 and augmented in 2003, followed a stretch when U.S. real GDP had expanded over 4.0% in four straight calendar years for the first time since 1966.

The eight-year long Reagan administration was associated with solid GDP and employment growth of 3.5% and 2.1% per year. The DOW Jones Industrial Average climbed 11.3% per year in spite of a single-day 22.6% plunge in October 1987, but the dollar on balance fell at a rate of 1.0% per year against the Deutsche mark, then its most important relationship. During the Reagan years, U.S. self-esteem recovered, and the United States played the role of military, geopolitical and economic superpower without regret. CPI inflation collapsed from 11.8% in January 1981 to 2.5% by June 1983 but at 4.5% when Reagan left office in January 1989 was still elevated by contemporary standards.

The eight-year stewardship of President George W. Bush ended in economic Armageddon that biased downward the economy’s performance for the whole period. Jobs went up on balance by a measly 0.1% per year between January 2001 and January 2009, and GDP advanced 1.6% a year, less than half the pace under Reagan and even less than average real growth in the Obama years, which also got distorted by the Great Recession. The dollar ended the Bush years having depreciated at an annualized rate of 4.4% against the euro, and the DOW dropped 3.5% per annum.

By contrast in the eight years of the Obama presidency, the DOW climbed 12.1% per year, jobs grew 1.0% per year, GDP advanced 1.8% per year, and the dollar advanced at an annualized rate of 2.5%. This better outcome, which included a shrinking fiscal deficit to GDP ratio, occurred despite tax increases that were implemented.

Last January 20th, when Trump was inaugurated, the dollar was stronger than now at $1.0643 per euro and JPY 115.19. The currency’s net decline against an index of other major traded currencies has been a bit more than 5%, but the direction has been upward since tax cut speculation took hold about two months ago. Since the centerpiece of the coming tax legislation is expected to be a corporate tax cut that designers predict will promote a repatriation of profits parked abroad, the presumption is that the dollar will benefit more this time than from earlier tax law changes.

Against that presumed support, however, must be weighed the protectionist predispositions of Trump. So far, the president has packed a big bark but shown little bite. His threats, however, and the withdrawal of the United States from multilateral trade deals have incentivized other national governments to fill the U.S. vacuum with a palpable urgency to seal multilateral trade deals relegating the United States and Britain, which has its own self-inflicted policy woes, to least favored status.

Note also should be taken that notwithstanding the growing differentiation of Fed policy from the monetary policies of the European Central Bank and the Bank of Japan, long-term interest rate differentials have not changed much. Compared to when Trump took office, the 10-year German bund and Japanese JGB yields now are a mere one basis point lower, while the 10-year Treasury yield is ironically down by seven basis points on balance.

There is the additional uncertainty regarding future Fed policy that’s related to coming leadership changes, which start with the changeover in chairmanship next February but extend considerably beyond that. The seven-person Board of Governors presently has three vacancies, and one of the four governors, Vice-Chair Quarles joined the Board only last month, replacing Stanley Fisher. Yellen could remain on the Board as an ordinary governor after January, but most likely she will choose to resign. There will then be four vacancies to be filled. Plus, New York Fed President Dudley, who serves as FOMC Vice Chair, plans to step down in the middle of next year and before his term would otherwise run out.

With such a large change of Fed personnel, it’s natural to wonder how Fed policy might be affected. While the presumption is that Jerome Powell represents a continuity choice regarding monetary policy, this changing of the guard can affect market behavior in ways that far transcend the chosen path of the federal funds rate and decline of the central bank’s balance sheet. Communication skills are often paramount. The handling of interest rates in the first couple of years of the European Central Bank’s existence in 1999-2001 was not controversial or inappropriate. But the first President of the Governing Council, Wim Duisenberg, was a poor communicator, and his style sowed confusion that weighed heavily on the euro, which fell to a record low in October 2000 of $0.8228 from a launching level at the start of 1999 around $1.1800.

Coming changes at the Federal Reserve, an “America First” approach to everything favored by the Trump administration, and the experiences that followed the last two big U.S. tax reductions suggest that the dollar may not perform as strongly in coming years as advocates of the tax bill are predicting.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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