The Next Great Debate at the Fed Will Be All About the 'Monetary Offset'

How will Yellen respond to Trump's fiscal policy?


The checks and balances imposed on President-elect Donald Trump's new economic agenda won't just come from Capitol Hill, but also from the Marriner S. Eccles Federal Reserve Board Buildings farther west on Constitution Avenue.

The real-estate mogul is believed to be prepping a massive fiscal expansion featuring tax cuts and an infrastructure spending binge, potentially funded by debt, at a time when the U.S. unemployment rate has fallen to levels historically consistent with full employment. This points to pricing pressures picking up steam as these expenditures arrive — and as such, bond yields have risen, with markets betting that Trump will be the inflation president.

How the Federal Reserve will react to this expansion of government spending and the inflation it may augur is anyone's guess, so one thing's for sure: the topic promises to become the next hot debate in central bank circles.

Economists at Goldman Sachs Group Inc. and Standard Chartered Plc., to name just two banks, have already suggested that the Federal Reserve will pursue a more aggressive hiking cycle in light of the fiscal impulse being sought after by the new administration. Markets appear to agree with this diagnosis: overnight index swaps imply that the amount of Fed tightening priced in two, three, and four years down the road has increased markedly since the U.S. election.

S0042FS 2Y1M BLC Curncy (USD OIS 2016-11-15 07-52-56
Source: Bloomberg

"With unemployment at the natural rate, growth set to recover as the dollar shock recedes, the dollar's drag on inflation beginning to fade, and underlying core inflation already at 2 percent, a potential fiscal stimulus risks creating a sharp increase in inflation as it has done in past such episodes when unemployment was low," Deutsche Bank AG's chief strategist Binky Chadha wrote in a report last month.

This view is consistent with the idea that the Fed will serve as monetary offset to Trump's fiscal plans, in essence moving to cancel out the positive effects on aggregate demand in an attempt to smooth the business cycle.

Monetary offset is a concept that different schools of economists count as a fertile subject of debate, with some areas of common ground. Recent market responses to the announcements of fiscal expansions in Japan and Canada suggest that the credibility of the central bank in achieving its inflation target, as well as other economic differences between nations — chiefly, the degree of slack that exists in the economy — all factor into the degree of monetary offset that can be expected. And it works in both directions: Nobel Prize-winning Economist Paul Krugman cited America's neighbor to the north as a case in which central bank easing helped the economy navigate through a large fiscal consolidation in the 1990s.

Moreover, the tightening of financial conditions — such as higher borrowing costs and a rising currency — that have occurred since the U.S. election imply that the mere pricing-in of an offset, rather than the actual institution of tighter monetary policy, can work to contract economic activity.

GSERFCI Index (Goldman Sachs Fin 2016-11-15 08-52-17
Source: Bloomberg

But will the Federal Reserve telegraph a steeper trajectory for rate hikes, confirming the market's initial reaction to the regime change? On that, the jury is still out.

Fiscal expansion may warrant higher rates, but it remains to seen how it will actually shape up, Richmond Fed President Jeffrey Lacker said on Monday. Dallas Fed President Robert Kaplan added that "if" broader economic policies come into play, monetary policy may have more "operating room to remove accommodation."

Speaking about the recent increase in longer term yields on Tuesday, Fed Governor Daniel Tarullo said "it's maybe an expectation that we'll want to watch and see how it manifests itself in actual movement or change in fiscal policy.''

It also matters how much room for improvement the Federal Reserve thinks there is for the U.S. economy.

"If you perceive the economy as being far from full employment or that you can run it hot before you have to worry about CPI consequences, then you probably have less of a monetary offset, or a less rapid one," said Tim Duy, professor at the University of Oregon, who delved into this discussion in a recent blog post. "But you can certainly say we're near full employment, and I think inflation will be returning close to target faster than the Fed expects."

This offset should not necessarily be construed as a negative development, he added, as it would ultimately allow monetary policy to regain its traditional effectiveness as the Federal Reserve moves away from the lower bound.

However, the central bank has also recently discussed the potential benefits of allowing the economy to run hot, which include reversing the supply-side damage done in the wake of the financial crisis and allowing the natural rate of interest to rise, which in turn would enable the Fed to raise its policy rate to loftier heights in the future. After years of hoping for a more active role for the government in facilitating an acceleration in growth, it would be curious development if monetary policy makers were to dampen such an expansion.

In that sense, "Trump may find an unlikely ally in Yellen," argued Neil Dutta, head of U.S. economics at Renaissance Macro Research, as she's a Fed Chair that doesn't seem too inclined to counteract the promised fiscal boost.

"Will overheating the economy pull capacity off the sidelines? Maybe or maybe not," the economist said. "But Yellen will make the case for maybe."

An extended period of low levels of market-based measures of inflation compensation and the disinflationary effects of a stronger greenback —  ahead of the implementation of any protectionist measures —  suggest the Fed may forego a more aggressive pace of tightening, Dutta added.

Moreover, if the Federal Reserve wants to act like a price-level targeting central bank — effectively making up for sluggish inflation since 2012 — then it can allow PCE inflation to run a full percentage point above 2 percent for several years, as New River Investments Portfolio Manager Matt Busigin observed.

Disentangling the source of any inflationary pressures will be a key challenge for the members of the Federal Open Market Committee wondering how to respond to the new administration's fiscal policies. An expansion of spending and tax cuts are only two Trump campaign planks that could impact inflation; others include restricting immigration and imposing trade tariffs. The central bank tends to look through inflation fueled by one-off factors, such as jumps in only prices, deeming them to be only transitory so long as households' longer-term inflation expectations remain anchored.

A combination of fiscal expansion, trade restrictions, and limited immigration might actually provoke a larger monetary offset than a mere expansion of government spending alone, argue Eurasia Group's Alexander Kazan, Karthik Sankaran, and Jonathan Lieber, as the additional measures will place an enduring limit on the ability of the U.S. to import disinflation from the rest of the world.

"This would suggest a need for the Fed to become less accommodative, which would also be consonant with the policy preferences of high-profile Republican monetary policy makers, who have been agitating against Fed QE and have pushed for a more ‘rule-based’ monetary policy," the trio writes.

There is also the question of just how stimulative Trump's fiscal policies will be — and whether the tightening of financial conditions to date will ultimately end up outweighing the positive effects on the real economy, perhaps necessitating an easier Fed stance.  While nominal bonds have suffered far more, Treasury Inflation Protected Securities have also been hit, with real yields moving higher since the election.

"If real rates rise due to anticipated supply, as opposed to anticipated fiscal spending, then the Fed is actually facing tighter financial conditions and a possible lack of real activity, depending on how you model the multipliers of tax cuts and infrastructure investments as well as the mix between the two," said George Pearkes, macro strategist at Bespoke Investment Group.

As such, any monetary offset "is going to depend a lot on the specific mix of policies, the nature of any inflationary pressures, the people on the Federal Open Market Committee interpreting them, and how much they want inflation to catch up," he concluded.

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