While Republicans were celebrating the passing and signing of the tax bill last week, many others were concerned about possible consequences of the tax cuts. One unintended consequence that could negate some of the possible economic gains is a stronger dollar. Part of the tax bill that is supposed to boost economic activity via corporate spending is the one-time tax cut to repatriated cash that companies bring back to the United States. Unfortunately, the success of this portion of the tax bill could eventually have a negative impact on the economy.
We have covered the companies with vast amounts of overseas cash in a couple of articles in the past few months. The most recent article talked about how the top six biggest hoarders of overseas cash have over $500 billion that they could possibly repatriate. So how could bringing that much cash back to the country be bad for the economy? Follow my thinking here.
First, the overseas cash is likely being held in a local currency or assets denominated in a currency other than the U.S. Dollar. In order for the money to be repatriated, the assets have to be converted into U.S. dollars. Depending upon how much in overseas assets are repatriated, the conversion back to U.S. dollars could create tremendous demand pressure on the dollar.
What happens when the demand for an asset increases? The price increases of course. And in the case of a currency, the price increases against other currencies. If the dollar rises too much, the demand for U.S. made products that are sold overseas decline and it ends up hurting domestic companies that rely on overseas sales for a large portion of their overall success.
One of the biggest goals of the tax bill was to boost the economy. President Trump and many GOP leaders have spoken about the GDP and the intentions of getting it to jump well above the current 3.2 percent growth rate. While that is a noble goal, it is going to be difficult to do without creating inflation. The unemployment rate is already among the lowest readings in the last 50 years. This means that the supply of workers is low and going back to the basics of supply and demand, when supply is low and demand is high, the price increases. In the case of the price for labor, it means an increase in wages will be necessary. This increased cost to the employers will be passed on to consumers and could increase the inflation rate.
If inflation starts to creep higher, the Federal Reserve will have to adjust interest rates accordingly and the recipe for keeping inflation in check is by increasing the Fed Funds rate. This essentially goes back to the supply and demand principles again as an increase in interest rates makes the underlying currency more attractive versus other currencies. So rising interest rates could also cause the dollar to rise against other currencies, which brings us back around to how a rising dollar could negate some of the positives of the tax bill. Of course this is all speculative and will depend upon how much overseas cash gets repatriated.
I personally think the tax bill will provide a mild boost to the economy, but not as much of a boost as the President and GOP leaders are predicting. And that could be the best outcome. My reasoning for doubting how successful the new tax structure will be is based on the fact that it is based on the supply side of the economic equation. Corporations are being given a gift of extra cash and how they handle it is up to them. If not enough of the savings are passed along to the consumer level, there won’t be an increase in demand, and the fact that demand hasn’t been increasing is why the economy is growing at such a modest pace.
I have argued for some time that the Fed should act more like a car dealer when it comes to handling interest rates. Instead of announcing intentions to keep rates down, they should come out and say they are going to raise rates on XX date by X percent. Consumers would likely respond by making purchases they had been putting off—buy the new car they had been considering, the new TV, etc.
Anything a consumer would buy on credit would likely see an increase in sales and that spending would have a ripple effect throughout the economy. Companies would have to increase production to rebuild inventories. This would either mean adding employees or working current workers more hours. Both cases would put more money in the hands of consumers in a variety of industries.
Only time will allow us to judge the success of the tax bill, but I personally wish those that crafted the bill would have put more of an emphasis on creating greater demand. Let’s hope that the unintended consequences of a rising dollar, higher interest rates and increased inflation are minimal.