Trump Trade, Travel Tactics Add to Uncertainty at Yellen’s FedBy
Fed chair says policy may end up very different than envisaged
Sorting out impact of Trump moves on economy won’t be easy
Donald Kohn has seen a lot -- from the dawning of Reaganomics in the 1980’s to the financial crash at the end of last decade. So the 40-year veteran of the Federal Reserve and former vice chair always hated it when someone spouted the hoary cliché of living in unusually uncertain times. Now though he thinks that old saw may finally be true.
As Fed Chair Janet Yellen and her colleagues sit down Tuesday for their first policy-making meeting of the new year, they’re faced with a wide swathe of unknowns generated by the presidency of Donald Trump, from the possibility of sweeping changes in the tax code and widespread government deregulation to the potential for stringent restrictions on immigration and trade. Each pose challenges for a central bank that is closing in on its goals of maximum employment and stable prices at a time when the short-term interest rates it controls are near record lows.
“Uncertainty is prevalent,” Yellen told the Stanford Institute for Economic Policy Research on Jan. 19. Policy could “end up behaving very differently” from what the Fed anticipates. The central bank, which is widely expected to keep interest rates unchanged this week, has penciled in three quarter percentage point increases for this year, according to the median projection of policy makers released last month.
Take immigration and trade, which pushed their way to the forefront last week with Trump’s temporary ban on visitors to the U.S. from seven Muslim-majority countries and his back and forth with Mexican President Enrique Pena Nieto over who should pay for a wall to divide the two nations.
Stricter curbs on foreigners entering and settling in the U.S. -- if indeed they come about -- would slow the growth of the labor force and the economy over time in a way that the Fed would be powerless to offset unless it wanted to risk higher inflation.
A trade war with Mexico -- or for that matter, with China, another favorite Trump whipping boy -- would be even more of a nightmare for the central bank. Higher tariffs on U.S. imports would both increase inflation and reduce economic growth by robbing consumers of purchasing power.
It would be “nothing but bad stuff going on,” Kohn, who is now a fellow at the Brookings Institution in Washington, told the National Economists Club on Jan. 26.
Allianz SE Chief Economic Adviser Mohamed El-Erian said he expects the Fed would react by easing monetary policy to prop up the economy. But Kohn said the central bank would have to be careful not to fuel a potentially dangerous increase in inflation expectations by pursuing too lax a stance.
Even those Trump policies that might be beneficial for the economy pose analytic puzzles for the Fed. The president told business leaders on Jan. 23 that he would cut government regulations by 75 percent. Trump backers argue that would lead to a dollar-for-dollar increase in corporate profits and economic activity.
But former Congressional Budget Office Director Douglas Holtz-Eakin, who also worked in the White House of President George W. Bush, said that calculation is too simple. Yes, President Barack Obama greatly added to business costs with stepped-up regulation -- to the tune of $800 billion during his eight years in office, according to calculations by the American Action Forum that Holtz-Eakin now heads. But doing away with those rules probably wouldn’t lift gross domestic product by anything like that amount.
Here’s why: Say a factory-owner had to buy a scrubber to limit pollution from his plant in response to new rules from the Environmental Protection Agency. That would add to his costs of doing business. But it would also mean more sales for the company producing the scrubbers. So doing away with the rule would have mixed effects on growth.
Sweeping modifications of fiscal policy also could affect the economy in unexpected ways. Economists have “limited ability” to predict the effects of tax and spending changes on the economy, with estimates of the impact of some moves varying “considerably,” Yellen said in a footnote to her Jan. 19 speech at Stanford.
Proponents of tax reform are already making the case that the Fed should react cautiously to an overhaul and not just respond with knee-jerk increases in interest rates.
“There’s a difference between policy actions that are likely to lead to overheating -- an underfunded infrastructure bill comes to mind -- versus policy changes that affect the supply side and productivity,” said Glenn Hubbard, dean of Columbia Business School
Former Fed Governor Kevin Warsh suggested that the Fed’s computer model of the economy wasn’t sophisticated enough to pick up the potential benefits of tax reform. “Composition and mix are more important than aggregate size in ways that Fed modeling can scarcely account for,” he told a meeting of economists in Chicago on Jan. 6.
The Fed does not just rely on its macroeconomic computer model to assess the effects of tax and government spending changes on the economy. It also has a small team of economists dedicated to that task -- a group that Holtz-Eakin said has “tons of expertise.”
U.S. central bankers have urged Trump and Congress to focus their efforts on budget changes aimed at increasing the long-run potential growth rate of the economy rather than on providing an immediate boost to demand.
Louise Sheiner, who was senior economist in the Fed’s Fiscal Analysis Section from 1997 to 2014, said much would depend on how quickly any effects on productivity and labor force participation come though.
“I don’t know if the Fed would respond less to policies that boosted aggregate supply if the effects on supply were only felt after many years,” Sheiner, who is now a senior fellow at Brookings, said in an e-mail. “I think they would say that the best way to ensure a healthy economy in the long term is to actually pay attention to their mandate.”