Fed Inclined to Lift Rates If New President Adds Budget Bumpby
Monetary policy won’t need to be as expansionary in that case
Shift in policy mix could prove troublesome for markets
The Federal Reserve is inclined to raise interest rates higher than otherwise if the next president pursues a more stimulative fiscal policy.
U.S. central bankers say they would welcome such a step as shifting some onus for supporting the economy away from the Fed. But they suggest they would offset the extra demand that a bigger budget deficit would spur by making monetary policy less stimulative.
The reason: With the economy already operating close to capacity, it’s not in need of an added boost right now.
“If we have more expansionary fiscal policy, we don’t need as expansionary a monetary policy,” Federal Reserve Bank of Boston President Eric Rosengren said in an Oct. 15 interview.
That sort of hand-off from monetary to fiscal policy could prove troublesome for financial markets that “have been both sedated and seduced by the prospect of low rates for longer,” said Joachim Fels, global economic adviser at Pacific Investment Management Co.
It also could pose some political problems for the Fed if it was perceived by lawmakers as working at cross-purposes with their efforts to spur economic growth.
Both Hillary Clinton and Donald Trump have said they would press for stepped-up government spending on infrastructure if elected president next month. Democrat Clinton also has proposed a bevy of other expenditure programs, including increased college aid, while Republican Trump has put forward a massive tax cut plan.
While Clinton in particular has talked of the need to contain the nation’s debt, many analysts see the path of least resistance for the next administration as more government red ink.
The resulting extra fiscal stimulus could total as much as around $100 billion a year, equivalent to about 0.5 percent of gross domestic product, according to economists David Mericle and Alec Phillips of Goldman Sachs Group Inc.
Such a boost could lead the Fed to hike rates one or two more times than otherwise, they wrote in a note to clients last month.
That estimate jibes with calculations put forward by Fed Vice Chairman Stanley Fischer in an Oct. 17 speech in New York.
He said increased government spending on the order of one percent of GDP would lift equilibrium interest rates by about 50 basis points, according to the Fed’s computer model of the economy. A tax cut of that magnitude would boost the so-called neutral rate by 40 basis points.
Research by San Francisco Fed President John Williams and central bank economist Thomas Laubach pegs the current neutral rate -- referring to the level that neither stimulates nor slows growth -- at just above zero percent, after taking account of inflation.
By holding rates below that level -- underlying inflation is now around 1.7 percent and the Fed’s policy-rate target range is currently 0.25 to 0.5 percent -- the central bank is pursuing what Fischer has called a “modestly accommodative” monetary policy.
An increase in the equilibrium rate stemming from an easier fiscal stance would allow the Fed to raise its target range while maintaining the same level of support to the economy.
“If government spending of some sort responded more strongly than it has during the most recent period, then we wouldn’t have to do as much,” Chicago Fed President Charles Evans said on Oct. 24 at the University Club of Chicago.
From the Fed’s point of view, that would be a good thing. That’s because it would give the central bank more room to cut rates before hitting zero percent should it need to ease policy to aid the economy.
“Low interest rates make the economy more vulnerable to adverse shocks that can put it into recession,” Fischer told the Economic Club of New York in his Oct. 17 remarks.
Regardless of whether fiscal policy is loosened, policy makers already intend to gradually lift rates in the coming years, starting with a quarter percentage-point increase by the end of 2016, according to projections released by the Fed on Sept. 21.
Recent polls show neither party will control both the House and Senate. If that’s the case, any big spending or tax measures pushed by a new president may get blocked by partisan gridlock.
Former Fed Vice Chairman Alan Blinder said he’s skeptical that fiscal policy will be loosened a great deal if Clinton wins the election, as seems likely based on recent voter surveys.
“She is promising not to make budget deficits bigger by her programs,” said Blinder, who is now a professor at Princeton University. “Whatever fiscal stimulus there is ought to be small enough for the Fed practically to ignore it.”
If the Fed does seek to offset easier fiscal policy with a tighter monetary stance, that would be a mirror image of what happened in the latter half of the 1990s, when Clinton’s husband, Bill, was president.
As the budget deficit shrank and eventually turned into a surplus back then, the Fed kept monetary policy looser than otherwise to support growth. And the financial markets prospered as a result.
Investors may not make out as well this time as the Fed reduces its support for the economy by raising rates.
“Markets are pricing in a lower for longer rate environment," said Pimco’s Fels. “Anything that challenges that could lead to a significant rise in bond yields, a steepening of the yield curve and could undo the eerie calm in the market for risk assets.”