by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was mostly quiet overnight.  Continued robust earnings are lifting equities this morning.  Here is what we are watching:

Abe to Florida: Japanese PM Abe will meet today with President Trump at Mar-a-Lago.  The meetings come at a difficult time for Japan.  Abe is facing domestic scandals that have weakened his popularity ratings, and he faces party elections in the fall which may lead to his ouster as PM.[1]  Japan was caught off-guard by the White House’s decision to hold talks with North Korea.  Abe fears the U.S. will focus on mitigating North Korea’s ICBM threat while leaving a potent short-range missile program in place, which threatens Japan.  The anti-trade rhetoric of the Trump administration also has to be a concern as Japan runs a large bi-lateral trade surplus with the U.S.  The chart below shows the rolling 12-month goods trade deficit with Japan.  Exports represent about 18% of Japan’s GDP.

The “dirty little secret” for Japan is that the JPY is deeply undervalued.  The chart below is Japan’s parity calculation using relative CPI.  The current fair value is ¥60.56 to the USD compared to the current ¥107.00.  A leg of Abenomics was a weaker JPY to buy time for restructuring.  In reality, the restructuring didn’t really occur (true restructuring would require increasing income to the household sector and reducing it to the corporate sector) so allowing the JPY to remain weak is counterproductive to U.S. interests.  So far, the president hasn’t figured out the exchange rate issue but, at some point, we expect him to use this tool in his trade policy.

We expect these meetings will be frustrating for PM Abe.  President Trump should focus on North Korea.  Japan lacks other allies and thus will need to accept whatever the U.S. offers.  Thus, the goal for Abe should be to at least give the appearance of camaraderie.

China’s GDP: This report is always taken with a degree of skepticism because it is so stable.  Growth rose 6.8%, although independent estimates put the real growth number closer to 4.8%.   Property investment rose 10.4% after being in single-digits since 2014.  Infrastructure spending rose 9.0%, which is unusually slow; usually this number rises between 15% and 20%.  Overall, China continues to ensure growth remains solid even if that means “goosing” real estate activity.  On a trade note, China indicated it will impose surcharges on U.S. sorghum exports of 178.6% as part of a “dumping” allegation.  China did indicate the finding is “preliminary,” which may mean it will be adjusted.  The U.S. exports around $1.0 bn per year of sorghum.  The majority of sorghum is grown in western Kansas, eastern Colorado and western Texas with a belt of production in south-central South Dakota.  However, some of the crop is planted in most states; nearly 40 of the lower 48 states record some sorghum planting.

Fed governor nominees: The White House confirmed it is nominating Richard Clarida and Michelle Bowman for two open positions on the Fed’s Board of Governors.  Clarida is a professor at Columbia University and is also on the payroll of PIMCO.  Bowman has extensive experience in community banking and will fill that position on the board.  We expect both to sail through the nominating process.  We have adjusted our “hawk/dove” spreadsheet.  Our current read on the two new nominees is that they are both centrists.  We have also pulled John Taylor from our potential roster of vacancies.  Marvin Goodfriend remains on the list, although his performance during his nomination hearing was weak enough that the administration may consider a different candidate.  We have also moved Williams to the NY FRB, although Bill Dudley will be in office until June.  We are estimating that a moderate will replace Williams at the San Francisco FRB.  Below is our view of the current composition of the board.

The current composition including projected members has an average of 2.64, making it mildly hawkish.  Last year’s voters averaged 3.20, a mildly dovish composition.  We are continuing to research Chair Powell and may change his position to a more hawkish leaning.  But, for now, we believe the new governors make the voting roster a bit less hawkish.

Russia cyberwar: The U.S. and U.K. issued warnings that Russia is targeting Western internet infrastructure with intrusions into home and business routers.  By taking control of routers, Russia can control internet traffic.  On a related note, President Trump decided to delay expected sanctions on Russia tied to its support of Assad.  UN Ambassador Haley indicated these would occur on the weekend news shows, but the president didn’t feel comfortable executing them.

View the complete PDF

---

[1] This is a possible, but unlikely, outcome.

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s relief Monday!  There was an attack on Syria but it was quite limited.  Equities have moved higher, Treasury yields have lifted, oil prices have dipped and the dollar is lower.  This is what we are watching this morning:

Parsing Syria: Late Friday, the U.S., U.K. and France launched a missile and bombing raid on three suspected chemical weapons sites in Syria.  Although it appears damage to the facilities was extensive, there was no leakage or any reports of casualties.  This suggests that Syria fully anticipated what targets would be hit and evacuated the facilities.  Russia was essentially warned to ensure no Russian personnel would be harmed.  The strikes were calculated to show American resolve against chemical weapons without expanding the conflict or threatening the Assad regime.  Although B-1 bombers did use the Qatar facilities in the attack, there was no evidence of direct Gulf State participation.

What can we take away from this action?  First, we think Trump’s recent comments about leaving Syria are where his preference lies.  The reaction of some right-wing populist commentators was interesting as there was strong condemnation of the attacks.  Right-wing populists are opposed to American hegemony and want an end to the inconsequential wars that accompany that position.   This group represents the president’s core supporters and he will be conscious of their opposition.  Thus, we would not be surprised to hear him return to the withdrawal position soon.  Second, the action will not deter Assad from his goal, which is to retake all the territory lost.  He may stop using chemical weapons to achieve this aim but attacking Syria for using chemical weapons but allowing his military to use indiscriminate bombing, i.e., attacking civilian areas and hospitals, is just as bad.  Why does the U.S. tolerate the latter but respond to the former?  There are probably a couple of reasons: (a) chemical weapons are weapons of mass destruction and the U.S. wants to restrict other nations from having them because they reduce America’s ability to project power, and (b) President Obama didn’t enforce the red line on this issue and President Trump is something of the “anti-Obama” in terms of policy.  In other words, he perceives that his base reviles Obama and thus does not want to do anything that smacks of a similar policy.

Additionally, the president really does want to end American hegemony.  We believe this process began with the last administration and continues with this one.  The majority of Americans appear to have tired of the role and don’t see any reason, in light of the end of the Cold War, to maintain America’s superpower role.  A recent Washington Post article[1] notes the president wanted Europe to “handle the Ukraine problem.”  Actually, the policy of demilitarizing Europe and taking over its security was deliberate—Europeans don’t get along (just look at how they handled the Greek debt problem) and have been the fount of two world wars.  Letting Europeans handle security problems will lead to a rearming of Europe and, a generation from now, an environment for conflict.  President Obama concluded that the U.S. could not afford to maintain stability in three regions (Europe, Middle East and Far East) and therefore prepared to remove American influence in the Middle East by allowing Iran to become the regional hegemon.  Trump’s election put that plan aside but its replacement is a free-for-all.  Leaving the Middle East may be necessary but the fallout could be difficult.  The refugee crisis in Europe is partly due to this withdrawal and, at some point, we would expect a disruption of oil flows.

The U.S. has announced further sanctions on Russian firms, those involved in Syria’s chemical weapons industry.  Expect much consternation but no real change in circumstances.

So, the worst outcome for the markets, which would have been Russian casualties, Iranian attacks on Gulf State oil facilities and a wider conflict, did not and probably will not occur.  The result has led to weaker oil prices, higher Treasury yields, dollar weakness and stronger equities.  The good news is that a broader war with deep U.S. involvement isn’t likely.  The bad news is that the Middle East will devolve, bringing further instability.

The currency dog: Sherlock Holmes, in the short story Silver Blaze, talked about the absence of an expected outcome.  In the story, there was a house abduction and the “dog didn’t bark.”  One of the oddities of the Trump administration has to do with the dollar.  At Davos, Treasury Secretary Mnuchin noted that a weaker dollar would support America’s trade policy aims.  The president quickly scotched the idea of dollar weakness for that goal.  However, pressing dollar weakness looks like a policy that a president intent on reducing the trade deficit should support.  Over the weekend, we learned that the Treasury won’t name several nations,[2] including China, as “currency manipulators.”  Naming China with this designation was part of Trump’s campaign, so the reluctance is something of a surprise.

We suspect the president, always conscious of the visibility of his actions, wants tariffs for the dramatic effect.  That way he can show his base something clear he is doing to punish trade miscreants in ways they can see.  On the other hand, the border adjustment tax, which was part of the tax reform discussion but jettisoned, and a weaker dollar would have likely been more effective than tariffs in reducing the trade deficit.  However, using these tools to affect trade is complicated and takes time.  The president appears to have made the decision that visibility is worth more than potential effectiveness.

Nevertheless, we note with interest a tweet from the president this morning that said, “Russia and China are playing the Currency Devaluation game as the U.S. keeps raising interest rates.  Not acceptable!”  Two issues are contained in this statement.  First, the president seems to have discovered that a weaker currency can offset the effects of tariffs, and second, this may be a shot across the bow to the Powell Fed that the White House is becoming uncomfortable with tighter monetary policy.  Will the president soon discover the benefits of a weaker dollar?  We will be watching to see if more comes of this; if it does, the dollar will likely weaken.

View the complete PDF

---

[1] https://www.washingtonpost.com/world/national-security/trump-a-reluctant-hawk-has-battled-his-top-aides-on-russia-and-lost/2018/04/15/a91e850a-3f1b-11e8-974f-aacd97698cef_story.html?utm_term=.dcfd4031c578&wpisrc=nl_politics&wpmm=1

[2] https://www.nytimes.com/2018/04/13/us/politics/trump-china-currency-manipulator.html

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] U.S. equities are rising this morning as earnings season begins.  As our numbers above indicate, earnings are expected to be robust and the releases this morning confirm that outlook.  Here is what we are watching:

Return to TPP?  All presidents learn on the job; there really isn’t any earlier position that prepares a person for the rigors of the presidency, although state governorships are probably the best training available.  Where one sees this clearly is in presidential debates when an incumbent is running for a second term.  The “newbies” are all talking about all the great things they will do, while the current president looks at them with eyes that suggest “you think it’s that easy?”  Both candidates wanted to kill TPP and TTIP.  It looked like a political no-brainer.  Americans had employment insecurity and the last thing they wanted was more foreign competition in the form of imports.  But, apparently neither candidate understood the real reason these trade deals were cobbled together.  If both trade deals were in place, the U.S. would have been the center of two enormous trade blocs.  Any nation outside the blocs would have been at a deep disadvantage.  It would have forced China and Russia, in particular, to enter the agreements essentially on America’s terms.  Instead, both candidates focused on the impact on U.S. jobs.  Some sectors of the U.S. job market would have likely been adversely affected by trade and thus both candidates promised to end the deals.  Now, President Trump is realizing that if an overarching goal of U.S. foreign policy is to manage and contain China, then TPP would be a really useful tool.  We would not be surprised to see the administration reverse course on TPP and, despite this morning’s comment to the contrary, the other 11 nations renegotiate parts of the agreement.

The Syrian War: The U.S. is putting together a significant assembly of military assets.  The U.K. and France have joined in.  Currently, there are four U.S. destroyers in the Mediterranean and two subs, with up to 400 Tomahawk cruise missiles available.  The U.S.S. Harry Truman will be in theater by late next week.  That adds an additional 300 Tomahawks and up to 90 aircraft.  B-2 bombers from Whiteman AFB in Knob Noster, MO are available.  There are over 100 aircraft at the U.S. facility in Qatar.  Britain is contributing 6 Typhoon fighter jets, two attack submarines and the H.M.S. Duncan, a destroyer.  France will also be contributing aircraft deployed from France.

This has the look of a broad and extensive military operation.  Syria is moving its military assets under the protection of Russian anti-aircraft and anti-missile systems.  President Trump has significant assets at his disposal.  Now we await what decisions are made.  In the run-up to a potential conflict, oil and gold prices have been rising.

Chinese data: As we note below, China’s credit growth, although up sequentially (mostly due to the New Year), is showing continued weakness on a yearly basis.  Total loan growth fell to 12.1% from 12.9% on a yearly basis.  China has a serious debt problem and Chairman Xi is trying to slow the growth of credit to arrest the problem.  However, slowing credit growth will certainly weaken the economy.  In the past, Chinese leaders have reversed course once it became apparent that growth was slowing.  Xi has amassed enough power to deal with slower growth; the real question is whether he will use that power.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It was a fairly quiet overnight session; the dollar reversed some of yesterday’s losses and equities are modestly higher.  This is what we are watching:

Ryan’s departure: Soon after last November’s elections, we framed the forthcoming political battle as “Ryan vs. Bannon.”  Now, both are gone.  Bannon was banished from the White House last summer and Speaker Ryan confirmed what had been rumored for some time that he isn’t going to run again.  Last November, our position was that President Trump wasn’t necessarily fully formed as a political figure and that the establishment (Ryan) and the populists (Bannon) were trying to get control of the president’s agenda.  Both figures are now gone because the president has established his political persona.  Trump isn’t as populist as Bannon had hoped—it’s important to remember that Bannon wanted to raise the highest marginal tax rate on households above 40% while cutting rates to lower income households.  Trump is too much within the establishment to sponsor that idea.  At the same time, trade policy, the growing fiscal deficits and Trump’s continued support for universal social spending (Social Security, Medicare) has made it clear to Ryan that his style of conservatism is no longer ascendant.  Thus, there is no reason for Ryan to remain as Speaker.

As we have noted before, our two-party system is really a form of forced coalitions and there are periods when the coalition groups within the parties are in flux.  This is one of those moments.  We don’t know for sure where all the various groups will eventually align but we strongly suspect that groups we currently think of as Republicans or Democrats won’t be the same in 10 years.

A walk back: Yesterday, President Trump caused quite a stir by suggesting an attack on Syria was imminent and warning Russia that missiles were coming.  This was something of a mistake; the military always prefers an element of surprise and tweeting about an incoming attack is counterproductive.  So, this morning, the president reintroduced an element of surprise by suggesting an attack may not happen at all (very unlikely) or will occur at some unknown date.  There are two things we are watching.  We expect an escalation from last year’s limited cruise missile strike which means (a) the U.S. needs more military assets in theater, and (b) the U.S. would prefer allies involved in this action.  The U.K. is considering joining the U.S. and we would expect France, which has long-standing ties to Syria, to also participate.  We would also anticipate at least some token participation by the Gulf Kingdoms.  On the first point, the U.S.S. Harry S. Truman has left port in Norfolk after extensive maintenance and training for the Fifth Fleet’s Area of Operations, which includes the Middle East.  Assuming it can reach the Mediterranean in 10-14 days, we suspect nothing major will happen before then.  Second, it will take some time to gather allies and coordinate a plan.  Thus, we still expect a military strike but not imminently.

A comment on equities: Whenever we have a period of equity market weakness, there are always concerns that equities are signaling economic weakness and a bear market is in the offing.  Our economic data indicator, which uses initial claims, commodity prices and consumer confidence, would suggest we are in a period of correction and consolidation but does not indicate an ensuing bear market.

The chart on the left shows the S&P 500 with our economic data indicator.  The indicator is constructed by normalizing the aforementioned economic data and creating an index.  The left chart shows the raw index; when it crosses zero, it indicates economic weakness and signals further weakness in equities.  However, it is somewhat “slow”; to correct this deficiency, we use the 18-month change in the indicator and the warning signal is when it crosses the red line, shown on the right chart.  This gives an earlier warning but avoids the false positives of a mere zero crossing.  As the charts indicate, there is no obvious danger coming from the high frequency data.

There are two caveats.  First, there is the usual “past performance doesn’t guarantee future performance” warning.  The second is that this is an economic model and should not be expected to signal warnings for geopolitical or political crises.

Energy recap: U.S. crude oil inventories rose 3.3 mb compared to market expectations of a 1.3 mb draw.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart shows, inventories remain historically high but have declined significantly since last March.  We would consider the overhang closed if stocks fall under 400 mb.

As the seasonal chart below shows, inventories are usually rising this time of year.  This week’s rise in stockpiles is normal.  Every week that fails to show a build on the seasonal pattern is a week where the seasonal factors become less bearish.  Although there is still time for stockpiles to rise, it will be virtually impossible for inventories to reach their seasonal norms.

Based on inventories alone, oil prices are undervalued with the fair value price of $64.54.  Meanwhile, the EUR/WTI model generates a fair value of $74.08.  Together (which is a more sound methodology), fair value is $70.92, meaning that current prices are below fair value.  Oil prices have been rising on geopolitical tensions but it should be noted that current inventory levels are supportive, as is the weak dollar.  If tensions remain high, the seasonal “flip” that will occur by early May will add to potential market strength.

View the complete PDF

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] It’s risk-off today; risk markets are lower on a swirl of issues that are weighing on sentiment.  Here is what we are watching:

Action on Syria: The president tweeted this morning, warning Syria and Russia that the U.S. is preparing an attack on Syria for its recent use of chemical weapons.  There are several known/unknowns with this action.  First, what will be the scope of the attack?  We see four potential outcomes.  It could be a mere symbolic attack like the one seen last year, where a salvo of cruise missiles hit various targets.  That event didn’t deter the Assad regime then and it won’t do so now.  The attack could also be broadened to strike chemical weapons dumps.  Such attacks do increase the risk of collateral damage, including triggering weapon spillage and inadvertent casualties of Iranian or Russian soldiers.  Third, the attacks could be broadened even further to include not just existing weapons but also production facilities.  This type of strike would increase the chances of collateral damage.  Lastly, the U.S. and its allies could directly attack Syrian military assets, including bases, aircraft, artillery, etc.  Collateral risks escalate with this option, but it would clearly get Assad’s attention.

The second “known/unknown” is the potential counter-response.  What will Russia or Iran do in response to a U.S. and allied attack?  Would Iran attack the Gulf States if they participate in airstrikes?  Would Iran target oil facilities?  Would we see a cyberattack in response?  Essentially, there are growing risks here, especially with a White House that contains more belligerent advisors than when a similar attack occurred last year.

We are looking for a broader attack and it may take a week to 10 days before the full event unfolds.  There are no aircraft carriers in theater at present.  Although there are significant U.S. military assets already in the region, if it is going to be an expanded attack we would expect at least one carrier group to be moved into position.  The CVN Theodore Roosevelt is in Singapore and could be in range within a week or so.  We also expect some participation from France, although it appears the U.K. has decided not to engage.  This event will offer insight into John Bolton’s influence; although regarded as an unabashed hawk, the role of the National Security Advisor is to offer the president options and advice.  The potential for escalation is elevated and may take some time to resolve.  Oil and gold are the greatest beneficiaries of this news.

Threats against Mueller: The media is rampant with reports that the White House is considering firing Special Counsel Mueller and it believes it has the legal authority to do so.  The consensus of legal opinion is that he doesn’t; only the Attorney General can do that and the current holder of that office has recused himself from the Russia investigation so the deputy has that role.  If the president doesn’t have the authority, we could see the spectacle of the “Saturday night massacre,” when Nixon ordered his AG Elliot Richardson to fire Archibald Cox.  Richardson refused so Nixon fired him.  Nixon then ordered Deputy AG Ruckelshaus to fire Cox; the deputy refused and was fired as well.  Nixon next ordered Solicitor General Bork to execute the firing, and a reluctant Bork did fire Cox (which probably prevented Bork from sitting on the Supreme Court).  Firing Mueller would get messy because it veers into the somewhat vague boundaries of constitutional power.  Usually, Congress sees such actions as interfering with its oversight of the executive branch and reacts.  As long as Congress is in the hands of the GOP, Trump might get away with removing Mueller.  However, Trump runs two risks.  First, Congress has historically reacted against the usurpation of its executive branch oversight and may turn on the president.  It’s important to note that most of the GOP leadership is establishment, not populist, and would not be overly opposed to quashing populism.  The establishment has gotten its tax cuts and may view the president’s actions as taking the party into areas where the elite would prefer to avoid.  Second, nothing would fire up the opposition more than removing Mueller.  The odds of the House flipping to the Democrats would be elevated (we note reports that Speaker Ryan is not seeking re-election), and removing Mueller would even put the Senate into play.  For markets, such turmoil would undermine sentiment; it would be negative for equities and probably bearish for the dollar as well.

Russian sanctions: Expanded sanctions on Russian figures close to President Putin have boosted aluminum prices as the Russian firm Rusal (486:HKG, HKD, 2.06) has been hit by sanctions.  U.S. regulators are warning British banks that their relations with Russian oligarchs could put them at risk.  The ruble is weakening and the small, but not zero, potential that Russian oil firms could come under scrutiny is probably helping oil prices this morning.

Facebook (FB, 165.04): CEO Zuckerberg generally held his own yesterday mostly because most of the questioners were completely ignorant of how not only social media works, but the internet in general.[1]  Only Ron Johnson (R-WI) nailed it when he asked Zuckerberg if his company should pay users for their data.  This is really the crux of the matter.  If social media is merely a constant focus group for advertisers, they should pay us for our time.  We don’t expect this train of thought to go anywhere.

Something of note: For the first time since the end of WWII, the Japanese Defense Force has created a contingent of marines.  The Japanese military has avoided such forces because they were seen as offensive units and its pacifist constitution outlawed such actions, therefore marines were seen as unnecessary.  Apparently, due to China’s growing threat and fears of likely U.S. disengagement, Japan has concluded it needs an amphibious force to protect its various island chains from encroachment.

Fed policy:  With the release of the CPI data we can update the Mankiw models.  The Mankiw rule models attempt to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.75%, up from 3.26%.  Using the employment/population ratio, the neutral rate is 1.68%, up from 1.25%.  Using involuntary part-time employment, the neutral rate is 3.22%, up from 2.58%.  Using wage growth for non-supervisory workers, the neutral rate is 1.67%, up from 1.28%.  The rise in core inflation, due in part to last year’s roll-off of mobile phone plan prices, has led to a significant upward lift in the Mankiw rule neutral rate estimates for all variations of the model.  If anything, this will increase the determination of the FOMC to continue on its path to hike rates.  We may get some insight from this afternoon’s minutes but, overall, it is reasonable to expect three more hikes this year.

View the complete PDF

---

[1] It was a bit like Dave Letterman’s comments about having a “twitter machine.”  https://mashable.com/2009/12/09/david-letterman-tweet/#.LThK4_1UkqQ

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Risk-on is the order of the day.  Here’s what’s driving it:

Xi talks: Chairman Xi spoke at the Boao Forum yesterday evening and made promises to open China’s market to foreign investment and lower export impediments.  He indicated that auto tariffs will be lowered.  The tone was conciliatory and would offer the Trump administration a path to de-escalate trade tensions.  We have seen a steady escalation of tensions since January which has clearly spooked risk assets.  Trade tensions are a major element of those concerns (the FOMC is the other).  However, a word of caution is needed.  Xi was rather vague in his comments.  In fact, there isn’t much new here from his speech in Davos in 2017.  Xi’s goal appears to be two-fold.  First, he wants to lower the “temperature” on trade and offer President Trump a face-saving path to lower tensions.  Offering to lower car tariffs is a clear but minor concession that Trump could take to declare victory and smooth relations.  Since the Trump administration hasn’t really offered what it wants to accomplish with trade, he could declare the autos as sufficient.  There was a second element to Xi’s speech.  China’s view is that it wants to be considered a rival superpower to the U.S. and end America’s unipolar moment.  Thus, he wants to offer China as an alternative to the U.S. and is portraying China as the defender of free trade.  This is preposterous; China may be a rising superpower but it doesn’t engage in free trade at all.  Not only does it interfere with exports, but its financial system is mostly closed and therefore its currency can’t be used for reserve purposes.  If one runs a trade surplus with China and holds CNY as a result, it’s difficult to invest those CNY in the Chinese financial system in an asset like U.S. Treasuries.  So, the bottom line is that the speech was mostly fluff but the fact that he at least tried to lower trade tensions is being well received by financial markets.

The deficit: Yesterday, the CBO released its new deficit estimates, taking into account the tax reform act and the recent spending package.  The results:

Clearly, the deficit is going to rise.  Here is the key point—either the deficit is going to expand growth beyond capacity and lead to higher inflation, or it is going to lead to a wider trade deficit, or some combination of the two.  The deficit, all else held equal, will shift the aggregate demand curve outward from the origin.  The intersection with aggregate supply determines the level of output and the price level.  In a closed economy, this usually leads to higher levels of inflation and higher nominal interest rates.  But, in an open economy, the excess consumption usually leads to increased imports and a wider trade deficit.  The trade deficit outcome is dependent upon (a) global capacity—if it is insufficent then import prices will rise, leading to inflation, and (b) the exchange rate and the willingness of foreigners to hold the financial assets of the deficit nation.  For example, when Venezuela runs a fiscal deficit, no one will hold its bonds and the result is higher inflation.  The U.S., a the provider of the reserve currency, is uniquely able to run fiscal deficits and rely on foreign saving to partially fund it.  However, if American policy is determined to reduce the trade deficit while simulateously expanding fiscally, the result will be higher inflation.

View the complete PDF