The Fed Must Live With Uncertainty Under Trump
The Federal Reserve’s announcement Wednesday that it would raise interest rates by a quarter of a point came as no surprise. The move, lifting its target band for short-term rates to 0.5 to 0.75 percent, was all but universally expected. The medium- or longer-term outlook for monetary policy, however, remains as uncertain as ever.
That’s largely because of the changing outlook for fiscal policy. President-elect Donald Trump has promised massive tax cuts and a substantial boost in infrastructure spending. On the face of it, this will provide the economy with a strong fiscal stimulus -- which would greatly affect the Fed’s future decisions. All else being equal, such a fiscal expansion would call for a faster tightening of monetary policy over the course of the next year and beyond.
The Fed’s new interest rate projections call for three quarter-point rises next year, rather than two as previously indicated. This reflects the view that the economy is already strengthening at a good pace, setting the fiscal issue aside. Here’s the catch: It can’t be set aside.
Executed carefully, a switch from monetary to fiscal stimulus would be good. You might say it’s overdue. Years of super-easy monetary policy -- interest rates close to zero and large-scale buying of government bonds -- have driven financial-asset prices to unsustainable highs, raising concerns about financial instability and adding to inequality as well. The Fed had little choice: Congress let fiscal policy tighten prematurely after the crash.
The economy still needs support from some combination of monetary and fiscal policy, albeit much less than before. As the Fed notes, the labor market is at or close to full employment, according to the standard measure. But there is still room to draw people who’ve stopped looking for work (and aren’t counted in the unemployment total) back into the labor force. Inflation is still below target, so a degree of stimulus is justified.
Fiscal policy should carry more of this load. Yet the question for the Fed -- and everybody else -- is exactly what to make of Trump’s fiscal promises. A Republican Congress will presumably cooperate with the next president in cutting taxes, but Trump’s ambitions for infrastructure are a bit vague. He says he favors private infrastructure investment over public. It’s unclear how much extra spending that plan would deliver.
The Fed’s difficulty doesn’t end there. There are legitimate questions (to put it mildly) about the Trump campaign’s claims about the budgetary costs of his tax cuts, which assume an implausibly sharp uptick in growth. Excessive fiscal expansion could cause alarm and even be self-defeating.
You see the problem. A measured fiscal expansion could extend and strengthen the recovery, but a reckless fiscal expansion might do the reverse. In the first case, monetary policy gets simpler. In the second, the Fed’s problems are only just beginning.
Aside from drawing attention to the danger, there’s little the Fed can do about this. The main lesson, rather, is for investors and politicians. One of the biggest mistakes of the past several years has been thinking that the Fed can do it all, and insisting that it should try. Future financial stability demands, among other things, a more realistic assessment of what the Fed can achieve, and better execution of sound fiscal plans.
--Editors: Clive Crook, Michael Newman
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