On the first Tuesday of November 1980, the U.S. dollar hit a low in foreign exchange markets after a long and steep decline. The election of Ronald Reagan as President was expected to mark a sharp departure from the stagflation of President Carter. While more than two months elapsed before President-elect Reagan and his team took office—and even more months passed before the promised tax cuts and regulatory reforms could pass Congress and be implemented—foreign-exchange and equity markets looked forward and quickly adjusted to anticipated economic conditions in the near future.
Now, 36 years later, financial markets again appear to reflecting the growing conviction that the newly elected President—together with a majority Senate and House of Representatives of the same party—will pursue policies that mark a departure from his predecessor. Based on statements made during the year-and-a-half-long campaign, financial markets appear to be reflecting a belief that:
- Congress will act quickly to pass tax-rate reduction and tax-code simplification for individuals;
- Congress will sharply cut corporate tax rates, triggering a potentially huge reflow of corporate profits that have been held overseas where they were earned in order to avoid being doubly taxed at the high prevailing rate in the United States;
- Onerous regulations of at least small and medium-sized banks will be relaxed, fostering a wave of de novo bank charters that will finance the formation and growth of job-creating small businesses;
- The botched overhaul of the complex system for financing health-care services will be substantially repaired;
- After an initial freeze of new proposed regulations in the pipeline, Congress will initiate a fundamental review that will roll back economically harmful regulations of energy, labor markets, the environment, and financial services.
While the post-election behavior of foreign-exchange and equity markets is consistent with expectations of a more prosperous U.S. economy, the reaction of bond markets is more complex. In part, rising bond yields may be reflecting an anticipation of a higher real rate of return on real productive capital as a result of tax reduction and regulatory reform. However, rising nominal interest rates may suggest that larger budget deficits and faster money growth will cause a higher rate of inflation compared with the past several years. The consequent higher interest rates will be welcome news to savers and institutions with large cash holdings, but the transition to higher yields means that the prices of previously issued bonds will fall—possibly significantly. That will either lock in current holders until the bonds mature, or will impose substantial losses if the bonds are sold prior to maturity.
The risks to this mostly favorable economic outlook are substantial. Statements made during the election campaign about foreign trade and immigration have not yet been translated into specific policy proposals. The large capital inflows implied by the stronger U.S. dollar would be reflected in an even larger current account/trade deficit. If that is misunderstood by a protectionist Trump Administration and its allies in Congress, tariffs and other anti-trade barriers would damage world trade and potentially abort the economic expansion.
Furthermore, the strength of the dollar on foreign-exchange markets and the rising stock market could be short-lived if inflation were to accelerate quickly to unacceptable rates, triggering an abrupt shift to restrictive money and credit policies. While many in government and the central bank believe that a mild rate of inflation is conducive to growth, the prospects of a return to the stagflation of the 1970s would necessitate a policy pivot at the expense of growth.
The pace of economic growth could also prove to be disappointing if the approach to immigration reforms proves to be an even larger obstacle to educated and highly skilled people seeking opportunities in a more prosperous America. Both national productivity and the pace of new business startups are enhanced by ambitious and entrepreneurial immigrants; that stimulus could be lost if new policies devised to address the problems associated with illegal immigration are poorly designed and implemented.
Like the early months of the Reagan Administration, the new Trump Administration will have advisers and Cabinet officials with different backgrounds and experiences; the diversity of viewpoints and approaches to policy options can be healthy, but also can seem chaotic or even dysfunctional to outsiders. However, Reagan went to Washington after eight years as Governor of California, and was guided by deeply held beliefs about the role and scope of the Federal government versus state and local governmental units. What became known as “Reaganomics” gave coherence to tax, trade, energy, environmental, and other regulatory policies.
A guiding economic philosophy of the Trump Administration has not yet been articulated, but it will be essential to achievement of sustainable policies. In the few weeks since Election Day, markets have reacted positively to the hope for better days ahead, but markets can be fickle and easily disappointed if concrete achievements are not forthcoming.