View on US interest rates and Dollar

The main issue being faced by US currently is how to increase government expenditure without hampering the fiscal deficit to a great extent. As per the current statistics from Economist, the budget deficit is expected to rise to $1.2 trillion in the current fiscal, nearly 8% of the US GDP. This would be the highest post 1940’s and worse than the era of high inflation seen in the early 1980’s. Let us take a step backward to the post war era in US. This was a period of gold standards and Keynesian economics. Increased government expenditure finally made it difficult for US to hold onto the gold standard. The money supply expanded less than two fold during 34 years prior to Nixon action and after that action, money supply expanded 13 fold. The revocation of gold standard played an important part in the high inflation experienced in late 1970’s.

The current high fiscal deficit coupled with the increase in money supply being made by the Fed by taking in collaterals (Fed takes in collateral from banks and increases their deposits being held with the Fed. No actual money transfer takes place, but the banks have that amount of capital free to be deployed) has the ability to increase the inflation and interest rates in US going forward.

This is a phenomenon that has been seen across economies which have faced economic crisis. US has been immune to the problem of being able to find investors who would readily buy the bonds it issued. The current interest in US treasuries has been primarily due to the decreased preference for risk. My view is that the risk aversion would decrease and in case other economies start recovering earlier than US, then it will be tough for US to find investors at low yields. The era of strong dollar has come to an end. The performance of dollar going forward would mimic the economy’s performance vis- a-vis other economies coupled with inflation rates. The strong performance of the dollar over the last 3 months should not be viewed as a long term shift but rather a short term unstable shift.