Fed Tightening vs. Fiscal Stimulus
It seems the impossibly fast pace of the news cycle continues to quicken. The past week’s headlines shifted between further geopolitical stress from North Korea, legislative drama in the Senate, Bitcoin’s meteoric rise in price, Dow 24,000, Michael Flynn’s plea deal and many other provocative but ultimately forgotten news items. The most important news items for financial markets are the debate on a U.S. tax cut and the path of policy of the Federal Reserve. Market participants started the week weighing testimony from Jerome (Jay) Powell’s Senate confirmation hearing, and ended the week weighing the implications of the imminent passage of the Senate’s tax bill. The focus on the tax bill was derailed briefly with breaking news on Friday of Michael Flynn’s plea deal with the special counsel at the D.O.J. The breaking news of the plea deal on Friday morning and the associated speculation about additional criminal charges caused a fairly large intraday swing in stock and bond markets. The S&P 500 Index traded down nearly 1.5% intraday to finish the day down 20 basis points (bps) in a volatile trading session. The stock market recovery was driven by hopes of easy passage of the tax bill in the Senate. The vote on the tax bill in the Senate ended up meeting market expectations early Saturday morning, passing along party lines. Beneath all of the salacious headlines, it appears the most important storyline for the market is that fiscal and monetary policy in the U.S. are set to diverge.
On Tuesday, Jay Powell provided written testimony regarding his nomination to Fed Chair and answered questions from ranking members of the Senate’s Banking Committee. Overshadowed by other dramatic events in D.C. during the week, the contents of Powell’s unexciting testimony is a far more important topic for investors. His testimony helped to provide steady assurance that he intends to operate the Fed’s policy within its stated mandate of creating conditions for full employment and stable prices. Furthermore, the testimony painted the picture of a disciplined nominee who will exercise prudent judgment over an independent and apolitical institution. While this news is not shocking or headline-worthy, it was important for Powell to reaffirm the Fed’s commitment to set policy based on data. This undertaking will likely be challenged early in his tenure (assuming confirmation) given the developing tax bill that will likely provide substantial tax cuts to businesses and individuals alike. Without adequate offsetting spending cuts, the deficit spending brought on through a decline in tax revenues may induce further inflationary pressures as economic activity will likely increase in the short run in response to the proposed tax cuts. The tax cuts will increase the degree of difficulty for the FOMC in setting policy as additional fiscal stimulus may create pressures that push a faster cadence in the Fed’s current moderately paced rate hikes.
The proposed tax cuts are inarguably expansionary. While the competing tax bills passed in the House and the Senate have differences in the form of individual tax rates and brackets as well as levels of popular credits and deductions, such as the mortgage interest deduction and child tax credit for individuals, in aggregate both bills have the same general intention. Both bills have created some consensus among budget economists. First, most economists agree that the bill will create increased economic growth in the near term as consumers and businesses will have more disposable cash to spend on goods and capital projects. The Tax Policy Center estimates that 2018 GDP will be boosted by 0.6% in 2018 and harmonize downward over the long term as the initial impacts of the tax cuts will diminish over time. However, this growth does not come without some associated costs. The second point of agreement among economists is around an increase in Federal budget deficits. Estimates on the increase in the federal budget deficit in the next ten years range from as little as $500 billion to as much as $1.8 trillion. Despite many claims that the tax bill will “pay for itself” through sustained increases in G.D.P. growth, there have been few credible analyses supporting such assertions. Congress’s own bipartisan Joint Committee on Taxation released its analysis shortly after the bill passed on Saturday morning. The report shows an additional $1.45 trillion in budget deficits over a decade. While all of these estimates are inherently murky and imprecise, and historically have underestimated the impact of tax cuts, it is more than likely that any finalized bill will boost consumer spending and corporate investment, and increase federal budget deficits for years to come.
Given the pending sea change in fiscal policy, the current course of monetary policy may be due to change as well. For most of 2017 the market has been enthralled with tax reform and strong fundamental data on corporate earnings and global growth. For the immediate future, it appears that the “Trump trade” which began last year following the election is back in vogue. U.S. equities continue to rally in light of a step up in corporate profits driven by the tax cut, and long term interest rates have recently continued their path higher in consideration of reflationary pressures. However, the one looming uncertainty that may not be appreciated by the market is a shift in Fed policy away from its dovish recent course and toward a more hawkish tone if the data supports such action. Should inflation accelerate for any reason, the Fed will likely adopt a more aggressive policy stance and that could take markets by surprise.
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