Yellen May See Inflation Risk in Deficit-Busting Trump Tax CutsBy
Fed already sees fiscal stimulus as upside economic risk
Trump focus is on spurring growth, not containing deficits
What President Donald Trump giveth to the economy with massive tax cuts, Federal Reserve Chair Janet Yellen may be tempted to taketh away with higher interest rates.
With the economy already near maximum employment, the central bank is inclined to use tighter credit to keep the economy from overheating as taxes are reduced and budget deficits increase.
Fed officials, who have penciled in two more interest rate increases this year and three next, have said they see possible fiscal stimulus as an upside risk to the economy. That risk is only magnified if Trump relies on more government debt, rather than offsetting tax code changes, to finance his cuts, as administration officials have indicated he might.
Trump’s proposal, an outline of which was announced Wednesday by Treasury Secretary Steven Mnuchin and top White House economic adviser Gary Cohn, potentially puts the administration on a collision course with Fed officials who have almost reached their economic goals and are in the early stages of pulling up ultra-low borrowing costs.
“The biggest tax cut in history has monetary policy implications,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, alluding to Mnuchin’s description of the plan. “If the package looks like it will increase the deficit, that will be an argument for more tightening, not less.”
Fed policy makers would have welcomed fiscal stimulus earlier in the expansion that began in mid-2009, when unemployment was still elevated and inflation was well below their 2 percent target. But now, with the jobless rate at almost a 10-year low and price pressures starting to build, they don’t see a need for a short-term prod from the federal government.
Administration officials have said the president wants to chop the corporate tax rate to 15 percent from 35 percent and to levy a 10 percent tax rate on cash that companies have stockpiled overseas. He also intends to slash individual income taxes, reducing the number of tax brackets to three from seven.
How the package is financed is important for the Fed. If a middle-income tax cut, say, is paired with limits on how much Americans can deduct from their obligations, then the immediate impact on demand and the economy is limited. If it’s not, it’s more likely to give a short-term boost to growth that could lead to a Fed response.
Trump’s budget director Mick Mulvaney said last week that the administration’s focus is on promoting economic growth, not on controlling budget deficits.
“Deficits are not driving the discussion,” Mulvaney, who is director of the Office of Management and Budget, said in a Bloomberg Television interview on April 21. “Deficits are certainly part of the discussion. But we’re not starting off saying, ‘How do we do something that’s deficit-neutral?’ We’re starting off saying, ‘How do we get economic growth?’”
Mnuchin has insisted that the tax cuts would be fully paid for. But here’s the catch: Most of that financing would come from an anticipated rise in economic growth -- and the impact that would have on government revenues -- and probably not from such changes in the tax code as the elimination of deductions. Mnuchin sees growth accelerating to 3 percent or more from the 2.1 percent it’s averaged during the eight-year economic expansion.
Even some Republican economists are skeptical of that claim. Donald Marron, who served on former President George W. Bush’s Council of Economic Advisers, said the administration’s estimate of the favorable feedback effects from lower taxes was “surprisingly large,” although he cautioned he hadn’t seen all the details of the plan.
Yellen told lawmakers in February that the central bank wouldn’t necessarily respond to a tax cut package with stepped-up increases in interest rates.
“Only if we think that it is demand-based and threatens our inflation objective,” would the Fed react with a tightening of monetary policy, she said.
The trouble is that a big deficit-financed package increases the chances of a potentially inflationary spurt in demand, said David Hensley, director of global economics for JPMorgan Chase & Co. in New York.
Of course, it’s far from a lock that Trump’s plans will get through Congress, where deficit hawks and budget procedures could lead to a significant scaling back of the president’s proposals.
“The Republicans aren’t really unified behind a big fiscal stimulus,” Hensley said. What’s likely to emerge is a smaller package that lifts gross domestic product growth by about a quarter percentage point in both 2018 and 2019, he said.
Fed staffers seem to more or less agree. In December, they lifted their forecast for GDP over the next few years “slightly” to take account of a more expansionary fiscal policy, according to the minutes of that month’s policy-making meeting. The staff saw the stimulative effects of a changed budget stance “substantially counter-balanced” by higher interest rates and a stronger dollar.
Yellen and the Fed are in a delicate position. She doesn’t want to be seen as an opponent of the president and his plans. But she also wants to avoid a big rise in inflation that would damage the economy and tarnish the central bank’s credibility.
“We would like to see fast growth, but we do have to control price inflation,” Yellen, whose term as chair expires early next year, told the House Financial Services Committee on Feb. 15. Trump, who has said he likes low interest rates, indicated earlier this month he’s open to renominating Yellen.
The composition of any tax reform plan also matters for the Fed. If the program induces companies to spend more on factories and equipment and in the process lifts productivity, officials have indicated that would be good news for the economy and the central bank. Why? Because in that case the faster growth probably would not spur higher inflation.
It still might eventually lead to higher interest rates, however. Fed Vice Chairman Stanley Fischer estimated last year that a tax cut on the order of 1 percent of GDP would lift the equilibrium interest rate for the economy by about 40 basis points.
Fed officials have suggested that that rate -- which neither stimulates or slows growth -- is currently close to two percent. They see it ultimately rising to 3 percent. Their rate target range now stands at 0.75 percent to 1 percent.