For most of the years since the 2008 financial crisis, central bankers around the world have pleaded with their counterparts in government for help.
They’ve asked for regulatory reform to unshackle markets and for greater fiscal spending to stimulate economies.
The election of Donald Trump and a potentially sympathetic Republican-controlled Congress raises the possibility that central bankers could get their wish in the United States. If it works, it could sweep the globe, finally convincing Europe and Japan to enact long-stalled reforms.
But that will raise a critical question for central bankers: What does it mean for interest rate policy if they finally get what they want?
Fed Vice Chair Stan Fischer said Friday that greater fiscal spending could change the Fed’s rate outlook and “ease the task of monetary policy.” But he didn’t offer up exactly how.
Candidate Trump proposed a massive $6 trillion tax cut for individuals and businesses, unspecified hundreds of billions of dollars for infrastructure spending, deregulation in banking, environment and energy, increased military spending along with a hands-off approach to Social Security and Medicare. The offsets: greater projected economic growth that he believes will send money flooding into the treasury and cuts to nondefense, discretionary spending.
There are so many wild cards in the deck right now, it’s difficult to game out how the hand will be played. Will tea party Republicans object to potentially massive increases in the deficit? Or will they be assuaged by his advisors’ projections (controversial among mainstream economists) that the tax cuts will pay for themselves through growth and deregulation?
Can even a Republican Congress agree to politically explosive cuts in the nondefense discretionary part of the budget which is growing smaller and smaller? Will that mean even bigger deficits?
The rise in Treasury yields since the election suggests markets are bracing for some combination of greater deficit spending, higher inflation, higher growth or higher rates from the Fed. It’s difficult to figure out what pays the bigger part.
For the Fed, a change in the outlook for government spending will meaningfully alter the outlook for rates and the economy.
Between 1990 and 2010, government spending contributed about three-tenths of a point to growth. That includes a ramp up in spending in 2009 and 2010 from a controversial fiscal stimulus package and automatic stabilizers — increased government payments for unemployment insurance and other government programs to help during tough economic times.
But from 2011 to 2015, government has subtracted 0.3 of a point from growth. So bringing back the prior average means that growth could end up swinging 0.6 higher. Instead of a 2 percent (or lower) underlying growth rate for the entire economy, it could be 2.6 percent, or higher if Trump’s plans ignite broader economic growth.
As Fischer suggested, a higher underlying growth rate, would mean a higher underlying neutral rate —- the rate that doesn’t slow or speed up the economy. If the neutral rate ends up rising because of these policies, then the Fed will believe it is more stimulative than it wants to be. That is, it’s actual rate could be judged to be too far below the new neutral rate.
It’s all a complicated way of saying, if the government does more to push up economic growth, theFed will have to do less. That could mean faster rate hikes, or more rate hikes.
The wild cards are whether Trump’s plans really will work. Many believed the last fiscal stimulus plan did little good, though supporters argued it kept the economy from falling further than it did. And many economists have been clamoring for the government to at least bring government spending back to its long-run averages of adding a few tenths of a point to GDP. Yet others point to massive deficits coming from higher spending on entitlements as the population ages.
Here are a few scenarios:
Scenario One: Trump gets much of what he’s proposed, and all he’s proposed works. In that case, growth offsets the rise in deficits. The Fed will need to hike rates faster and higher.
Scenario Two: Trump gets much of what he’s proposed, including better growth, but large deficits along with it. “Rates will go up higher than they are now, budget deficits will rise quickly as a percent of GDP and that will require fiscal contraction eventually,” said Lou Crandall, chief economist at Wrightson ICAP. The result will be stop and start fiscal policy and a Fed that might have to hike and then reverse course.
Scenario Three: Trump gets much of what he’s proposed, but gets large deficits and not much growth. In that case, the Fed may raise rates initially, expecting higher growth, and then have to turn tail even more quickly and head back down if the economy doesn’t respond.
In any event, the Fed will likely tread carefully, gauging the political chances of Trump’s plans becoming law and making judgments about just how effective they will be.
What is clear, is that in no scenario — except the unlikely one where Congress completely shuns the president-elect’s proposals — is Fed policy likely to be the same as was forecast before the surprise election result.