For monetary policy wonks, today is Christmas
At the time of writing, the time is 2:08 pm on December 14th, 2016. Clearly, it’s in the middle of the holiday season, but for a special class of economists and market watchers, today is a special day. Specifically, we received the official statement from the Federal Reserve Board about monetary policy only a few minutes ago, at 2 pm. The all important Federal Reserve Rate was moved up another 25 basis points, to a target range of 50 to 75 basis points.
In previous articles and blog posts, most notably our February 2012 article “Recent changes at the Federal Reserve”, we described how the Federal Reserve uses monetary policy and other measures (like quantitative easing) to maintain prices. Feel free to read the prior article for a review on the institution and its dual-mandated goals. For the purposes of this article, the key fact to keep in mind is that the Fed wants to keep price inflation low and stable.
Despite the implications of higher borrowing costs, the stock markets seem to have absorbed the widely anticipated rate hike with modest change. Similarly, the upward trend already experienced by long maturity bonds yields has finally been matched by a spike in low maturity bond yields (the two year US government rose to a six year high) after the Fed pushed up the floor on rates.
Rates changed. So what?
So, all in all, the increase in rates was a long-anticipated change with modest near-term consequences. The most dramatic shift in short term bond rates wasn’t a jolt of unexpected volatility. If anything, the shift reflects a re-harmonization between the long and the short end of the yield curve. Fed Chairman Janet Yellen said, during her follow up press conference, that this rate change should have minimal effect on the markets. So, why is this rate shift supposed to be important again? Why should regular people care?
Let’s consider some interesting elements of this rate shift. First, this is only the second time since the Great Recession (2008) that rates have moved higher. We’ve experienced almost a decade of falling or bottomed out rates. After years of asset price growth and the tightening labor market (with an official unemployment rate of 4.6%), only now have rates climbed again. There is evidence to suggest that the underlying price dislocations build up over time (e.g. the housing bubble and burst in the 2000s), so there could be a great deal of built up inflationary pressure embedded in the system. There has been inflationary pressure building for a while, but there were mitigating factors which had offset the pressure. The previous year’s drags on headline inflation – like the collapse of oil prices – will start expiring on trailing 1 year inflationary measures. More recently, the price of oil has recovered to $50 a barrel just on the news of OPEC cooperation. Even if energy prices only stabilize after OPEC’s recent plans to limit output, the energy marketplace will no longer be a deflationary offset. We will be able to measure this more effectively next week when core and headline CPI numbers are published.
Second, after several contentious meetings between Fed voting members, the decision to raise rates was unanimous. Prior to this meeting, policy doves preferred to wait for corroborating data before committing to a rate hike. Policy hawks worried that waiting for data meant letting inflation go unchecked. In a unified voice, the Fed board members see inflation rising towards their 2% goal and, with energy hikes, a likely range from 2.5%-3.0% achievable by the end of 2017.
Third, the announcement from the Fed came with statements supporting gradual increases continuing through 2019. In other words, they expect sustained inflationary pressure to continue for years. They won’t try to shock the market with a big hike all at once but they are aware that these steps will not be sufficient to keep inflation in check.
The wild card
All of these systemic factors would have been newsworthy by themselves, but there is an additional level of policy volatility to consider. The big wild card is the November election. Rate hikes are thought to be deliberately postponed until after the November election so as not to affect the outcome of the race. Now that it’s happened, there is a counteracting force which should be considered: how does the outcome of the race affect monetary policy. Had Clinton been the President-elect, the prevailing wisdom was that monetary and fiscal policy trends would have gone relatively unchanged from the Obama administration. However, nobody knows with certainty what policy decisions are going to occur under the actuality of President-elect Trump. There are signals that many of his proposed policies could be inflationary which could accelerate or magnify the pressure which was already building.
Let’s consider some of the potentially inflationary possibilities in Washington following Trump’s win. Originally, a unified Republican Congress under Senate leader Mitch McConnell and House leader Paul Ryan had been proffered as a bulwark against fiscal overreach from a hypothetical Clinton presidency. However, Paul Ryan has more recently signaled increased willingness for regressive tax policies under Republican ally President Trump. Senate leader McConnell has positioned himself more as a deficit hawk. So, the news is mixed from Congress.
Ryan and McConnell have suggested “revenue-neutral” approaches to deficit spending, like offsetting reductions in corporate tax rates by eliminating tax deductions on foreign costs-of-goods sold or removing tax-breaks for specific companies. There are complications from changing the structure of the tax code in this way, but there is an intellectual consistency with creating a lower, more level playing field. More worrying, Paul Ryan has used different calculations than the nonpartisan Congressional Budget Office when suggesting his proposals on individual and household tax cuts, like including higher future assumptions of taxes based on unrealistic interpretations of growth and spending trends. Perhaps he’s subscribed to the “deficits don’t matter” mantra.
Ignoring the pros and cons of various tax cut proposals, the distribution of benefits from de facto deficit spending via tax cuts is inflationary in the short term. Let us posit, in the long term, growth rates improve sufficiently with lower taxes to offset the immediate loss in tax revenue. Moreover, quality of life is maintained as productivity catches up, more goods and services are produced, making everyone better off. Even with that presumption, in today’s terms, injecting additional dollars into the economy without immediate additional commensurate production means there are a higher number of dollars chasing the same finite set of goods and services. So prices go up and we’ve got inflation, at least for a while. Again, tax cuts can still be the right move, but we’re considering consequences to monetary reality for now.
Besides monetary matters, let’s consider some other policy proposals from President-elect Trump. Immigration reform was the cornerstone of his presidential bid. Assuming the United States deports millions of cheap immigrant laborers in a bid to restore higher wages for Americans, the increase in subsequent increase in wages will translate to higher prices, particularly for those goods and services previously fulfilled by the expunged labor force.
From a fiscal perspective, it’s hard to know which policies will get enacted, in what order, and what the effects will be. President-elect Trump has had a myriad of proposals with significant increased spending – estimated at $5.3 trillion dollars over 10 years by the C.B.O. Some spending, like infrastructure or education programs, has the potential to improve current and future productivity. Some spending programs and tax benefits, like veteran health expansion or the repeal of the estate tax, have fewer possibilities to improve productivity. The wisdom of various initiatives can be considered one-at-a-time and the conclusions may vary, but the practical upshot of this spending bonanza is worrying to economists. Why? The US economy, by most objective metrics, is healthy and reasonably well utilized. We’ve passed full employment target of 5%. Corporate profits are healthy. GDP is solid. Individual and corporate balance sheets are healthy. Deficits are stable and borrowing costs are low. Judging from President-elect Trump’s campaign promises, some of his expectations are unrealistic. For example, he has suggested during his campaign that the US was losing ground to foreign competitors like China and India with higher growth rates than the US. However, the rule of diminishing returns for developed nations suggests that the amount of fiscal stimulus necessary to create the sort of growth rates common to emerging markets are enormous.
Is inflation in the future?
The irony is that several potentialities of a Trump could completely undo this theorem for additional inflation. For example, imagine that negotiations on trade deals lead to unilateral impositions of US tariffs on imports, retaliatory actions, and a resulting trade war which stifles global growth. The slowdown of global trade activity could be so ruinous to overwhelming any potential inflationary actions on a domestic front. There are too many unknowns to make any projections with certainty. However, the possibility for extreme price fluctuations, either positive or negative, is higher under the forthcoming administration.