The surprise election of Donald Trump continues to be the focus for investors. The prospect of a new policy environment, and the various attendant risks, have led to a rethinking of economic forecasts and significant repricing across asset classes.
The outlook for the Federal Reserve (Fed) is, of course, highly dependent on how this new policy environment develops, and how the various risks will be navigated. Rather than attempting to map out how monetary policy will evolve under the myriad number of possible outcomes, this note sets out a more modest goal of making three general observations about the Fed that we think will be relevant this year:
- The Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communications will likely have a hawkish tilt this year.
- Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates.
- The relationship between the White House and the Fed is a wildcard, but doesn’t necessarily have to be contentious.
1. The Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communications will likely have a hawkish tilt this year. Since the election there has been a marked increase in investor optimism, as is apparent in sentiment surveys and in a range of financial market prices. The prospect of a pro-business White House relaxing the regulatory environment has been a key driver of the shift in sentiment. In addition, many expect that lower taxes and higher government spending will boost near-term growth, although the magnitude is a subject of debate and is dependent on the details. Optimists also argue that easier fiscal policy could shift the burden from monetary policy to fiscal policy, thereby leaving the US with a more sustainable balance between the two. A final reason for optimism is the prospect for improved productivity and consequently a higher level of longer-run growth for the US economy.
As members of the Fed form their own expectations and plans for the coming year, we suspect there will be a consensus on the appropriate response to a realization of easier fiscal policy: tighter monetary policy. To some extent the bias toward tightening monetary policy in order to offset optimism around fiscal policy was already apparent in the December Federal Open Market Committee meeting, when the Fed increased its median expectation for rate rises more than expected.
Given the preponderance of arguments for offsetting easier fiscal policy with tighter monetary policy, and the consensus these arguments will engender within the Fed, it is likely that this theme will feature prominently in Fed communications this year. As such, Fed communications are likely to have a somewhat hawkish tilt. This would be a departure from the dovish tilt that communications have had over the past few years. Of course the Fed is also aware that a hawkish tilt in its communications influences market prices—in particular the front end of the yield curve—and by doing so tightens the policy stance preemptively. Whether that preemptive tightening is an opportunity or just a preview of things to come is the subject we turn to next.
2. Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates.
The previous section focused on how the Fed would respond to easier fiscal policy and faster growth. Importantly, this is a conditional observation. IF fiscal policy is loosened and growth picks up, THEN the Fed will likely respond by tightening monetary policy. That said, absent more concrete developments, the Fed is not under any current pressure to hike. The inflation outlook is far from threatening, there is considerable uncertainty around the size and shape of the coming fiscal changes and the new administration’s policies carry a number of risks that could significantly curtail the positive aspects of looser fiscal policy.
The sharp fall in inflation expectations at the beginning of last year forced the Fed to make a dovish course correction, and as a result the Fed delivered only one hike instead of the planned four. Inflation expectations have increased since the election and are currently well above their lows. That does not mean, however, that the Fed now feels pressure from the other direction. Far from it. After the recent bounce, inflation expectations now sit comfortably in the middle of their range over the past few years. So while inflation expectations are no longer constraining the Fed from hiking, neither are they motivating the Fed into accelerating the pace of hikes. Indeed, the middling level of inflation expectations suggests that a “gradual” pace of rate hikes is about right.
3. The relationship between the White House and the Fed is a wildcard, but doesn’t necessarily have to be contentious. For perhaps obvious reasons, the topic of the relationship between the Fed and the White House has once again become top of mind, and indeed has become one of the most frequently asked questions in our recent client interactions. The reality is that the relationship is complicated. It is exceptionally hard to have much conviction on how this relationship will evolve. However, and in contrast to the many articles warning of a “collision course,” we’d note that the initial developments are far from dire. Regardless, this will be a topic of ongoing interest and here we provide some initial thoughts on two important aspects of the relationship.
The most important point of interaction will be when President Trump chooses the next Fed Chair. Janet Yellen’s term as Chair ends in February 2018, and a new Chair would likely be announced sometime in the second half of this year. President Trump’s preferences for the next Fed Chair are unclear. As a candidate he criticized Chair Yellen for keeping rates low, leading some to conclude that he would favor a more hawkish chair. However, on another occasion Trump said that he liked Chair Yellen because she is a “low interest rate person” and admitted that he, Donald Trump, is also a “low interest rate person.”5 This suggested straightforwardly that Trump would favor a more dovish chair. If pushed, we’re inclined to think the White House’s desire to generate faster job growth will favor dovish candidates. A final point is that Trump’s selection of cabinet members suggests a willingness to look outside the normal list of candidates. In the case of his selection for Fed Chair, Trump seems unlikely to choose somebody with a PhD in Economics who teaches at a top university, and instead he may gravitate towards somebody with market or business experience. As a consequence, the next Fed Chair could very well be somebody who most investors are not currently familiar with.
Another question is whether the White House will try to exert influence over Fed decisions in other ways. Over the last few decades, investors have become accustomed to Fed officials asserting their independence from politics and perhaps more importantly, to White House officials largely refraining from commenting on monetary policy. Of course the sensitivities on this issue reflect a more checkered past in which White House was much more active in influencing monetary policy. In the past, the White House has tried to steer the Fed through friendly requests based on close relationships (for example, Arthur Burns’ relationship with President Nixon and G. W. Miller’s relationship with President Carter), or in some cases by acting more forcibly to shift the Fed’s stance (for example, Paul Volcker’s retirement was accelerated after Reagan’s Treasury Secretary James Baker appointed two governors opposed to Volcker’s policy stance). It remains to be seen whether the current détente continues or whether Trump more closely resembles Nixon, Carter and Reagan in this regard. On one hand, Trump commented on Fed policy on a number of occasions during the campaign. On the other hand, the initial signals from the new administration suggest it is proceeding cautiously on this front. For example, in his Secretary of the Treasury nomination hearing, Steve Mnuchin said he would refrain from commenting on the short-term moves in the US dollar, focusing instead on the long-term trend. This was a subtle, but important distinction that should be at least somewhat comforting for the Fed to hear.
There are of course many other dimensions to the relationship between the Fed and the White House. Issues to watch include: How will the White House interact with the Fed on regulatory issues, including with regards to banks where the Fed is primary regulator? How will Treasury respond if and when the Fed ends their policy of reinvesting maturing securities on their balance sheet? While there may be competing interests in any of these issues, there is also room for optimism that conflict can be avoided. The credible list of potential Fed governors and Mnuchin’s careful rhetoric regarding the US dollar perhaps represent steps in the right direction.