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The outlook for the US economy shifted following the election result. The market’s reaction was initially negative, but quickly reversed. Equities rose, interest rates moved higher, and the dollar strengthened as the GOP’s proposals surrounding prospects for fiscal spending and tax reform came into focus. The upshot of a fiscal package is that it boosts both the deficit and inflation expectations. While this boost will dissipate over time, the deficit will likely remain. The critical aspect of the fiscal package will be the execution of tax reform, and the method used to pay for it.
Simultaneously, the Citi Economic Surprise Index for the US improved, moving from negative to positive. The index indicates that the economy has been performing better than expected. This better data reinforced the positive sentiment suddenly engulfing the prospects for the US economy.
Economists tend to agree that infrastructure spending is less simulative than tax cuts. In a National Bureau of Economic Research* study spanning nearly 40 years of fiscal adjustments across developed economies, they find fiscal stimulus done through tax cuts and paid for by spending cuts the most effective method of stimulating economic growth. Having a two-pronged, longer-term stimulus package could effectively reinvigorate some demand and inflation for a time. The size of payments, the frequency or the permanence and length of policy shifts also plays into effectiveness of a stimulus.
The importance of intentional design and delivery comes from the theory of mental accounting. The basic thrust of the theory, as applied to stimulus packages, is that people react differently to different sized stimuli. A large sum is more likely to be considered an asset, and smaller amounts treated as income. The Federal Reserve** has found that when people considered the “lump sum” of the 2011 payroll tax cut, they intended to spend ten to eighteen percent of it. But after it was doled out paycheck by paycheck, they spent far more—twenty eight to forty three percent.
With US yields and inflation expectations rising, the US dollar has surged. While this is a headwind to US exports and dollar priced commodities, it benefits the international central banks who have been attempting to spur inflation and growth. The Japanese yen, the Euro and the Chinese RMB have all weakened substantially since the US election, providing a tailwind to their inflation pressures and export growth. Though it is not going to reverse the underlying problems in each area, a strengthening dollar provides a window of hope for monetary policies to achieve their intended goals. For China, the dollar surge provides an opportunity to continue to weaken the RMB amidst pressure to further devalue.
With inflation potentially accelerating, the Fed will now debate how far inflation should run before tightening. This provides the Fed with the potential opportunity to increase fed funds beyond where it would have otherwise. By letting inflation run higher, it allows the Fed to normalize at a faster clip down the road. Granted, the prospect of raising the inflation target from 2% seems unlikely near-term, but has been debated publicly by Fed Presidents before. Whether the Fed allows inflation to run will be critical to how Fed policy unfolds in 2017. For the time being, the Fed is poised to raise rates in December with the market pricing in 96% chance.
*Alensia, Alberto and Ardagna, Silvia “Large Changes in Fiscal Policy: Taxes versus Spending”, National Bureau of Economic Research: 2010.
**Graziani, Grant; van der Klaauw, Wilbert; and Zafar, Basit “A Boost in the Paycheck: Survey Evidence on Workers’ Response to the 2011 Payroll Tax Cuts”, Federal Reserve Bank of New York Staff Reports: 2013.
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Quarterly and Monthly Notes
Third Quarterly, 2017
Second Quarterly, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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The opinions expressed herein are those of Avalon Advisors, LLC investment professionals at the time the comments were made and may not be reflective of their current opinions. Nothing herein shall be construed as investment advice or a solicitation or offer to purchase or sell any securities.