Logical Inconsistency

11/30/-1  Author: Dr. Charles Lieberman, Chief Investment Officer

Senior Fed officials, notably including a number of Fed doves, have been commenting repeatedly in recent weeks how undesirable it would be for an expansionary fiscal policy to be implemented right now by the new Trump Administration. However, this newly revealed view is totally inconsistent with the Fed’s position that the labor market is not tight and that there remains meaningful scope for additional expansion. For quite some time, the Fed has argued that the labor market retains plenty of slack, which has been its primary justification for raising interest rates only very slowly over an extended period of time. If the Fed really believes that there is lots of room for incremental hiring and that inflation will remain at bay for another year or two, a more stimulative fiscal policy should be welcomed, not discouraged. In our judgment, interest rates are too low, the Fed’s monetary policy is overly accommodative, and this will become increasingly apparent as inflation increases in response to economic growth that keeps unemployment well below full employment. The Fed seems to be in the process of shifting its view and adopting our perspective, albeit slowly.

The Fed’s position for a few years has been that the economic recovery is modest, unemployment is declining albeit slowly, inflation is nicely contained, and there is still quite a bit of room for growth, so there’s no urgency for hiking interest rates. Fed Chair Janet Yellen has repeatedly taken the position that assorted labor market measures implied that significant excess labor supply remained to be hired, despite the decline in the unemployment rate to levels that signaled full employment in the past. The Fed’s quarterly projections, including its latest released with the December 2016 minutes, also suggest that the Fed does not expect to even hit its 2% inflation target for another two years, further reinforcing the notion that meaningful slack remains in the economy. Investors have heard this message and taken it to heart, so the bond market has priced itself for interest rates to rise only very gradually over the course of the next few years. The Fed and the bond market seem to be on the same page.

This harmonious relationship is now coming undone in the face of the possibility that fiscal policy may become more expansion oriented. The new Trump Administration has indicated it would like to cut personal and corporate tax rates and increase spending on defense and infrastructure. Most observers understand this may enlarge the budget deficit, even as it supports faster economic growth. Yet if the Fed were really of the opinion that the economy still retains considerable slack, it would be logical for Fed officials to welcome this new tack for fiscal policy to reinforce its expansionary oriented monetary policy. Instead, the Fed seems to be lobbying for the new Administration to avoid implementing any kind of expansionary oriented fiscal policy. Moreover, those who discourage fiscal stimulus blame the tight labor market. This Fed stance on fiscal policy is totally incongruent with the Fed’s description of the economy or its current monetary policy.

Indeed, the Fed’s position on the economy seems to have changed directly in response to the new outlook for fiscal policy. The Obama Administration did not support any new expansion oriented fiscal initiatives, leaving the entire job of promoting economic growth and reducing unemployment to the Fed. Under Bernanke and Yellen, the Fed did a great job, bringing down the unemployment rate to 4.6%, one of the lowest rates in many years, which made up for the lack of fiscal stimulus coming from Treasury. However, the Fed has somewhat overplayed its narrative of a weak expansion in order to justify its still highly accommodative monetary policy. As already noted, the “modest” expansion (Janet Yellen’s description of the economy, not mine) has been more than sufficient to bring down the unemployment rate to levels that have historically been universally regarded as full employment, while wage rates and inflation have both increased, only moderately so far. These processes have been underway long enough that the Fed should have started to gradually normalize interest rates earlier, but Yellen expressed a preference to run the economy “hot” because she believed material slack remained in the labor market and to make sure jobs are available to less skilled workers. No longer. Apparently, the mere prospect of a more expansionary fiscal policy is sufficient to cause the imagined slack in the labor market to evaporate nearly overnight, even before any fiscal policy is articulated clearly in the form of proposed legislation, let alone passed into law by Congress. Indeed, during her speech before the Commonwealth Club of California on Wednesday, she characterized employment as near its maximum level and inflation as close to the Fed’s objective, quite a change of view within a short period of time. Nonetheless, in response to the very first question posed to her on the subject of income inequality, Yellen indicated quite clearly that the Fed has limited tools to reduce inequality, so she prefers a strong economy so unskilled, unemployed workers can find jobs more easily. What is now clear is that the Fed would like to do what it can to reduce income equality as an objective, despite lacking useful tools to help. But, with labor slack disappearing, it will soon become dangerous to keep rates so low.

It remains our view that the Fed is already somewhat behind the curve in normalizing interest rates. With a Fed funds rate below 1% and a 10-year Treasury yield of around 2.40%, only marginally above the Fed’s official 2% inflation target, monetary policy remains highly accommodative and fully expansion oriented. Even before the new Trump Administration is able to implement any of its fiscal programs, possibly even before it can fully express its fiscal plans, we expect inflation to breach the Fed’s 2% objective. This has already occurred for all the primary inflation measures, except for the Fed’s preferred measure, the core personal consumption deflator. But that will also soon breach that 2% level. In this context, it was very significant that Yellen suggested publicly that a 3% funds rate represented a neutral monetary policy, since by its own projections, the Fed will not get there until 2019 or later.

The market has still not woken up to the realization that monetary policy is too accommodative or that the interest rates are too low. Bonds have sold off sharply since the election, as investors recognized that a more expansionary fiscal policy is coming. But, the decline in bond prices has not yet allowed for the impending change that is coming from monetary policy, either voluntarily because the Fed changes its tack, or involuntarily because inflation kicks up well above the Fed’s tolerance. We expect interest rates to move up significantly. And, we think this will be a positive development, since it will more properly price the cost of capital to borrowers and provide better returns to investors.

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