originally appeared in the
on 19 December 2016.
The Federal Reserve’s decision to raise interest rates last week was the easy
part. Synching up monetary policy with new US fiscal policy and the global economy could be more difficult.
Since the election more than a month ago, investors’ reassessment of US economic prospects and the ensuing dramatic
repricing of stocks, bonds and inflation expectations no doubt increased the Fed’s confidence that the US economy no longer requires “emergency” monetary
policy. Already encouraged by the economic data — a 4.6 per cent unemployment rate with rising core measures of inflation — the Fed (according to its
widely scrutinised “dot plot”) is considering three more hikes in 2017.
The question for investors now is how will the Fed’s plans to normalise interest rates in 2017 fit with the potential sea change in US fiscal policy under
a Donald Trump presidency and volatile global markets.
Under a Trump administration, aggregate demand in the US economy could eventually get a boost from a fiscal package of tax reform, tax cuts, and infrastructure spending. And depending
on the details of any legislation that gets enacted, these policy changes could potentially lift the supply side and the pace of productivity growth of the
economy as well.
However, the risk today is that markets are pricing in more fiscal stimulus than we are actually likely to get in 2017. Debating, marking up bills and
passing tax reform will take time and any effort to boost infrastructure investment will only come on line in 2018 or later.
That could create awkward timing in which bond yields and the dollar will continue rising next year in anticipation of fiscal stimulus that might not be
felt until much later. Were this to happen, financial conditions would tighten next year without an offsetting boost from fiscal policy, and the Fed would
need to take this into account when calibrating the pace of rate increases. To put it bluntly, the Fed would be inclined to let the bond market vigilantes do some of the tightening for them.
Inflation could also complicate the Fed’s lift-off plans. Since the Fed announced an inflation target of 2 per cent in 2012, actual consumer prices have
consistently run below the target.
Since election day, measures of break-even inflation from the TIPS market have rebounded sharply, with the closely watched market gauge rising above 2 per
cent for the first time since spring 2015. If inflation rose materially above the Fed’s stated 2 per cent target, Chair Janet Yellen and her colleagues
could be tempted to raise rates faster than expected to avoid criticism that they are “tolerating” an economy that is running too hot.
The markets are pricing in a roughly 80 per cent chance that the Fed hikes at least twice next year, and roughly 50 per cent chance they hike three times
or more. In a “stagflation” scenario, economic growth fails to rebound in 2017 because fiscal policy has yet to kick in but strong dollar and tighter Fed
create a headwind that is not offset.
Longer term, the Fed and markets may well need to revise their estimate of what Ms Yellen has called the neutral federal funds rate or “the value of the
federal funds rate that would be neither expansionary nor contractionary if the economy were operating near its potential”.
Stronger US growth from supply-side policy and a rebound in business and consumer confidence would be predicted to lift the neutral rate, but estimates of
the magnitude vary widely. Importantly, as research and empirical evidence reveals, the neutral rate in the US — or any country — is a function of global
growth, saving, and risk appetite and not just domestic macroeconomic factors. While the US election potentially changes the outlook for domestic growth
and reflation, it has not materially changed the outlook for global expansion, saving, and risk appetite.
Markets have priced in a federal funds rate of less than 2 per cent in 2019, at the low end of the estimates of the neutral range. This may well rise over
time as the handoff from monetary policy to tax reform and infrastructure investment becomes a reality. But in a world of global capital flows there will
be a limit to how far US rates can diverge from global interest rates without triggering volatility in markets and a much stronger dollar that reduces
That will make it much more difficult to predict longer term where the Fed goes from here.