US Fed’s rate strategy is up for a rewrite

Higher interest rates are on the way. That, anyway, is the prediction increasingly baked into financial markets. President-elect Donald Trump’s potential policy agenda — big tax cuts and new infrastructure spending — seems to point in that direction.

And the Fed raised its benchmark interest rate by a quarter of a percentage point, with plans for more increases next year. But what if that’s wrong?

There’s no doubt that the stated goals of Trump imply that rates will be higher in a couple of years than they are today. Indeed, any stimulative fiscal policy from the Trump administration could well face an equal and opposite tightening of monetary policy by a Fed that raises interest rates.

The central bank will seek to prevent too much inflation from breaking out in an economy it believes is getting close to operating at its full potential, which means Trump’s stimulus might run up against the counter-stimulus of the Fed chief, Janet L. Yellen, and perhaps that of her successor.

But it’s worth looking at the two big ways that these forecasts could be wrong, and worth considering that the era of low rates might stick around a bit longer than some of the post-election discussion suggests. First, the Trump agenda might pack less of a growth punch than some have imagined. If so, you would expect the same cautious approach to rate increases from the Fed.

Second, even if the economy does start growing faster, future Trump administration appointees could change their tune on the desirability of higher interest rates. That has been the pattern with other populist politicians of the Trump mold around the world. Politicians, once in office, tend to find that they like low interest rates.

It’s easy to envision a Trump administration pushing for cheaper money.

Post-election rally

On the first point, it’s worth diving into the details of the Trump policies that led to the post-election day market rally in stocks and the sell-off in bonds. He wants to enact major tax cuts, for one, which all else being equal, would tend to create a short-term boost in economic growth and higher interest rates.

But there are some early signals that the Republican lawmakers who actually have to pass any changes to tax law, especially those in the Senate, are wary of tax cuts that would increase the budget deficit as much as Trump’s campaign plan would. “My preference on tax reform is that it be revenue-neutral,” Senator Mitch McConnell, the majority leader, told reporters.

Another big plank underneath the idea that Trump’s economic policy will be stimulative is an expectation that he will embrace a large-scale infrastructure spending package. But while Trump mentioned that idea in his election victory speech, he hasn’t put much meat on the bones of the plan since.

The details matter a great deal for how much an infrastructure plan could lift growth. For example, tax credits that make the finances of building toll roads more favourable are less likely to create a huge lift in activity than government spending on upgrading physical infrastructure outright.

So on both tax cuts and infrastructure, there’s no guarantee that the actual scale of stimulus will match some of the early post-election talk. Economists at JPMorgan Chase, for example, are forecasting economic growth of just under 2 per cent for both 2017 and 2018 — about the same as the pace of the last six years.

And that’s before factoring in the risk that some elements of Trump economic policy could end up being a drag on growth. Think of a trade war with China or Mexico, immigration restrictions that limit the supply of labour or geopolitical disputes.

New projections

All that gives the Fed every reason to take a wait-and-see approach to shaping its policy. If the Trump economy really starts to take off, the Fed could move more aggressively to raise rates. But it will do that based on actual evidence and data rather than the president-elect’s words.

One way to interpret new projections released by the Fed is that leaders of the central bank now expect to raise rates three times in 2017, not the two they had previously expected. That’s based on top Fed officials’ median forecast for where their benchmark interest rate will be at the end of next year, which rose to 1.4 per cent, from 1.1 per cent.

But Yellen seemed to play down that shift in her comments in a news conference, calling it a “very modest adjustment”. That led Fed watchers to expect that she is more inclined to move slowly on rate increases, even if some of her colleagues on the Federal Open Market Committee are ready to act more aggressively.

She also said that “changes in fiscal policy are only one of the many factors that can influence the outlook and the appropriate course of economic policy,” suggesting that the Fed is watching the overall economic environment, not just what comes out of Capitol Hill and the Trump White House.

If Trump’s Fed governors choose to keep rates low

That leads to the other possibility, in which the economy accelerates at the risk of overheating. History is littered with examples of politicians in that circumstance pressuring their central banks to keep rates low to encourage growth.

In 1972, it was Richard Nixon, pressuring Fed Chairman Arthur F. Burns to keep money flowing freely in the economy to help his re-election chances. In more recent times, populist right-wing politicians in Hungary and Turkey have undermined their central banks’ independence, pushing for lower interest rates.

Fed board

There are two vacancies on the Fed’s seven-member board of governors already, and Yellen’s term as chairwoman expires in February 2018; the term of the vice-chairman, Stanley Fischer, is up in June 2018. Add it up, and within 18 months of taking office, Trump could have appointed a majority of the Fed’s board, including its chairman and vice-chairman.

That doesn’t mean that Trump nominees for those jobs would necessarily refrain from rate increases if they believed they were warranted. Many potential Republican nominees for the Fed have opposed the low interest rate tendency of the central bank under Yellen and her predecessor, Ben S. Bernanke.

For the past few administrations, the accepted practice has been that presidents should refrain from weighing in on monetary policy and let the Fed act independently. But Trump has described himself as a “low interest rate person” and was willing to scrap that precedent by attacking Yellen by name during the campaign.

Nor is the Fed the ultimate arbiter. To be technical about it, if the Fed kept its short-term interest rate targets low in the face of rising inflation, long-term interest rates — which are determined by the bond market — would probably move up significantly.

If there’s one thing we know about Trump, it’s that he doesn’t feel bound by the traditions that have governed how recent presidents have acted. And that means that the future of US interest rate policy, like so much else, is up for grabs.