U.S. monetary policy morphed dramatically to a “new normal” of persistently depressed interest rates since the 2008 credit crisis, but with the advent of a dynamic new administration, the Federal Reserve may have to move back toward old normal.
In raising the federal funds rate at year-end, the Fed reiterated further hikes will be “only gradual,” but the meaning of gradual could evolve yet again. If President Donald Trump and the Republican Congress reduce tax and regulatory burdens as promised and achieve faster GDP growth, Fed policymakers will need to readjust their thinking on interest rates.
Before the election, a consensus developed that GDP potential, and in turn the “equilibrium” real rate and the long-run funds rate, had plunged. The “neutral” funds rate had been lowered 135 basis points since January 2012 to 2.9% (assuming a “real” rate of 1% and 2% inflation).
As the neutral rate ratcheted lower, the actual rate path became ever shallower. When the rate-setting Federal Open Market Committee finally left the zero lower bound in December 2015, FOMC participants projected four 2016 rate hikes. That was revised down to two by March; we got only one.
As recently as September, officials were projecting two 2017 rate hikes. But the December “dot plot” anticipates three. The neutral rate was bumped back up a tenth to 3%. Clearly, the prospect of Trump stimulus is already changing the monetary calculus.
Chair Janet Yellen says the shift is “really very tiny.” Indeed the projected funds rate at the end of 2019 is only 25 basis points higher. But the Fed may need to do more if Trumponomics works as advertized — admittedly a big “if” given growth-stunting demographic and global realities, not to mention legislative/bureucratic inertia. As Yellen says, “there is considerable uncertainty about how economic policies may change, and what effect they will have on the economy.”
Trump has vowed to slash the corporate tax rate from 35% to 15%; incentivize repatriation of $2 trillion in overseas profits; cut individual income taxes; roll back regulations and repeal and replace Obamacare.
If increased investment then boosts now flat productivity, GDP potential and labor force participation, the funds rate path may need to be steeper; especially if faster growth brings higher inflation and/or asset price bubbles. Growth itself is not inherently inflationary, but if the economy breaks out of its 2% post-recession slough, we could find monetary policy is not so “moderately accommodative” as we’ve been told.
Yellen is fully aware of these issues. Already, while denying having advocated a “high pressure” or “hot” economy, Yellen has backed off of past assertions that the economy has “room to run.” She insists the Fed is not “behind the curve,” but acknowledges, “We will have to adjust our thinking as things evolve.”
Sharp stock, dollar and bond yield rises since the election seemingly herald faster growth. Treasury Secretary-designate Steven Mnuchin claims “we can absolutely get to sustained 3% to 4%” GDP growth.
There are potential pitfalls. Tax cuts coupled with a $1 trillion infrastructure spending plan could balloon the federal deficit. If Trump’s saber-rattling against China triggers a trade war, the Fed could face a different challenge: global recession. And given Trump’s propensity for tweeting, perceived capriciousness might prove counterproductive. Alternatively, if Trump success invalidates the Fed’s unambitious 1.8% long-run GDP forecast, the Fed might raise rates too slowly and find it must play catch-up — always a dangerous game. But Fed policymakers likely will adapt to the needs of a more robust economy by raising rates more steeply than planned.
Yellen has vowed to serve out her term through Feb. 4, 2018, and while most current members of the Board of Governors are Democrats, it’s doubtful their actions will be politically motivated. One would hope Trump appointees will also be apolitical.
Policymakers will need to be nimble, thick-skinned and have the courage of their convictions. Trump has already shown himself willing to browbeat, calling Yellen “highly political” during the presidential campaign. Don’t be surprised if he and his advisors blast the Fed for subverting his policies, as did members of the Reagan and Bush administrations in the 1980s. Congressional threats to Fed independence could escalate too.
Eventually, Trump policies, if successful, could have implications for the Fed’s “unconventional” quantitative policies. For more than a year, the Fed has said it will prevent its $4.5 trillion balance sheet from shrinking by reinvesting proceeds of maturing securities until funds rate hikes are “well underway.” The FOMC is mulling long-run policy implementation, but it could decide to allow some balance sheet shrinkage by curtailing reinvestments and rollovers sooner than expected.