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 tighteningfor them.
