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Fed’s policy: the ball is in the camp of Congress…

As expected, the Fed hiked its fed funds rate by 25bp to 0.50-0.75%. But, unexpectedly, the anticipated number of rate hikes (median projection) was revised up from 2 to 3 hikes for 2017, sending a hawkish signal.

Is the hawkish signal the prelude of an acceleration in the pace of normalisation?

We doubt this, for several reasons:

  • The US economy is close to the end of its cycle. In addition, potential growth has fallen since the Great Recession (with a slower increase in the working-age population and a slowdown in productivity). The level of growth that we expect for 2017 (2%) would struggle to maintain the pace in 2018 without the support of fiscal policy.
  • Corporate leverage is close to an all-time high and it does not bode well for capital expenditure (which remained under pressure in H2 2016).
  • A faster pace of monetary normalisation would prove counterproductive. The subsequent tightening of financial conditions (stronger USD, higher interest rates) would rapidly put growth under pressure.

Assimilating a period of reflation with a period of out-of-control inflation would be a mistake. It is true that both core and headline inflation have accelerated over the past 12 months. But these two metrics have remained at exceptionally low levels since the current cycle started (mid-2009). Average inflation over this period has fallen to its lowest level since the early 1960s. There is no genuine inflationary threat in the US even though inflation is likely to accelerate next year. We are a long way from an inflationary boom. True, the Fed needs to anchor inflation expectations by hiking rates but there is no need to move away from the gradual pace. This is all the more true since USD appreciation will exert disinflationary pressure

Fiscal policy is responsible for the Fed’s more “hawkish” stance

  • Indeed, fiscal policy has taken centre stage since Mr. Trump was elected, as he promised to stimulate the economy through a large-scale stimulus. Monetary and fiscal policies are intertwined. And, as stated by Stanley Fischer in late November, “certain fiscal policies, particularly those that increase productivity, can increase the potential of the economy (…). By raising equilibrium interest rates, such policies may also reduce the probability that the economy, and the Federal Reserve, will have to contend more than is necessary with the effective lower bound on interest rates.”
  • The simulation results from the model used by the Fed’s staff indicate that a fiscal shock scaled to 1% of GDP increases the neutral fed funds rate by 40 to 50bp in the long run.
  • There is a great deal of uncertainty about what the US Congress can deliver in 2017. We believe that a fiscal stimulus of this magnitude (i.e. 1% of GDP) has little chance of being passed by Congress next year as most Republican Congress members insist on deficit-neutral tax cuts (this is very different from what Donald Trump promised during his campaign). In terms of fiscal policy, bear in mind that Congress has the last word.
  • Empirical studies suggest that fiscal multipliers are much lower when the economy is at full employment. When GDP is close to its potential, wages and core inflation tend to accelerate more rapidly. In that case, the Fed usually responds to changes in fiscal policy by tightening its monetary policy which exerts downward pressure on growth (with some lag).

In other words, the Fed is likely to remain very cautious next year. We are sticking to our views and expect two rate hikes in our central scenario in 2017. However, should fiscal policy be more proactive than we expect, the Fed would no doubt support the reflationary trend by hiking its key interest rates throughout 2017, possibly even more than 3 times. But, at the end of the day, the rebalancing of the policy mix (tighter monetary policy, easier fiscal policy) is likely to have a small impact on growth on a two-year horizon.

 

 

 

 

 

 

 

BOROWSKI Didier , Head of Macroeconomic Research
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Fed’s policy: the ball is in the camp of Congress…
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