Interest rates volatility has emerged with a vengeance as the bond market adjusts to the news of the election of Trump.

In America, investors have switched gears from expecting slow, non-inflationary growth into a world of inflationary growth. Indeed, inflationary expectations have altered the path of future Fed rate increases and the shape of the yield curve.

Given the huge size of the U.S. economy and the significant influence of its financial sector, worldwide investors are now expecting deficits to generate inflation in excess of 2 per cent. Inflationary expectations made a sharp U-turn this past week from a steady downward movement to a rapid uptick. But do higher budget deficits always foster higher inflation and, in turn, higher interest rates?

Crowding Out .Deficit financing may generate higher interest rates if government has to coax the private investor to subscribe to new government bond offerings. If savings by the private sector is insufficient to absorb the new issuances, then the extra borrowing will take place at the expense of private investment projects. The yield on government debt will rise to encourage investors to switch to government bonds and away from the private sector--- a situation often referred to as “crowding out”. But crowding out has a negative effect on private sector investment plans, as it  reduces the amount of funds available, thus curtailing  private sector expansion plans.

Today, governments have had no problem in raising funds, even in an era of very low interest rates. At the same time corporate issuances have been at the highest level in decades, as the corporate sector re-financed at ever lower rates .The entire capital structure in the private sector now reflects the new era of low long term interest rates.

Monetizing Debts. Deficits can lead to inflation if the central banks work hand-in-hand with the government to buy the new debt issuance. If higher deficits provoke the central bank to increase the money supply to purchase securities, then this could generate higher inflation. Again, this is not today’s environment. After nearly a decade of increasing the monetary base by just about every central bank in the world, aggregate demand remains weak--- hence the cry for fiscal stimulus. The use of non-conventional measures e.g. quantitative easing, has had no significant impact on economic growth. So, that route to inflation has not worked.

While the shock to the bond market of a Trump election has raised bond yields, the rates are no higher than they were in beginning of 2016. And, with so much uncertainty--- and skepticism—surrounding the nature, size and timing of government deficits, long term rates may not necessarily continue to move up. The reality is we know very little about the budget plans. Campaign promises do not always translate into government policy.

Now, the Fed has signaled that it intends to raise the Fed funds rate before year’s end. So, monetary policy will not likely add to an inflation created by government spending. And, in fact, this might do the opposite to keep aggregate demand in check. A combination of tighter monetary policy and looser fiscal policy might well generate the much desired non-inflationary growth.

Comparison to the Reagan Tax Cuts. Many Republicans look to the experience of the 1980s fiscal stimulus programs as a guide for the future. But this comparison is not valid, since the Reagan government had the great advantage of a very expansionary monetary policy to augment its fiscal policy. Today, monetary policy is expected to tighten as the Fed signals rates will move up as the Fed maintains its vigilance regarding inflation. The 1980s was a decade in which inflation decelerated. So, the comparison to the success of the Reagan era does not stand up.

In conclusion, it is far too simple to accept the notion that the recent back up in government yields will be quickly matched by higher inflation. Look around the world, and particularly focus on the so-called advanced nations. Are they about to spring sharply away from the low inflation? We don’t think so.

And while the U.S. economy will be favourably stimulated by an increase in budget deficits, remember that it takes time for the induced private spending as well as the promised infrastructure spending to make their mark. 

At the same time, after nearly 7 years of a somewhat subpar economic expansion, the U.S. finds itself with a possibly over-valued currency. This will lead to a slowdown in world trade which will have a negative impact on  the U.S.

In other words, this new political environment does not suggest to us a quick return to an inflationary world.