Untimely Fiscal Stimulus Is a Bond Nightmare
Policy makers at the Federal Reserve disagree as they try to sort through the case for interest rate hikes. Some think that an increase should be deferred until the inflation rate resumes moving toward the 2 percent target; others remain comfortable with gradual raises in anticipation that the tightening labor market will increase inflation pressures.
The new complication is the increased likelihood of a fiscal stimulus package that reinforces growth. Investors still assume rates will rise only very gradually, as indicated by long-term yields in the bond market. These uncertainties and contradictory views may soon be resolved because inflation is likely to accelerate and that could be reinforced by an untimely fiscal stimulus.
Public statements suggest that a number of senior Fed officials would prefer to see evidence of faster inflation before they would be willing to follow up a nearly certain 25 basis-point rate hike at the upcoming December Federal Open Market Committee meeting. Most central bank officials speak openly of their surprise that inflation moderated over much of 2017 despite the progressive tightening of the labor market.
The purpose of hiking rates is to contain brewing inflation pressures. So if inflation remains benign, there would be no satisfactory justification for the Fed to raise rates. Policy makers could simply allow unemployment to continue to decline. But almost all economists believe that joblessness cannot fall to zero without severe inflation pressures. The Phillips curve may have shifted, making it an imperfect policy gauge, but no one should expect that growing labor scarcity can be sustained without meaningfully faster inflation unless the laws of supply and demand have been repealed.
More recent data hint at a resumption of the rising trend in inflation seen before last spring. The last two core personal consumption deflator reports both came in at 0.2 percent per month, a 2.4 percent annual rate that is comfortably above the Fed’s 2 percent target. Wage inflation, the largest component of the cost of producing gross domestic product, has also re-accelerated, rising to 2.8 percent over the latest 12 months. It will garner close attention when the November employment report is released Dec. 8. Thus, there remains a very solid case to justify a December rate hike that has been well-telegraphed by Fed speakers, including Governor Jerome Powell, who was named to replace Chair Janet Yellen. But if recent data prove indicative, the disagreements and uncertainty within the Fed may soon become moot.
Developments in fiscal policy are also changing the calculus very quickly. There is a clear need for structural fiscal reform to encourage capital investment and to support gains in productivity. But we are also getting a sizable fiscal stimulus program that is poorly timed given that the unemployment rate is already down to 4.1 percent. Job vacancies are at record levels and business leaders have been complaining for some time that it is difficult finding the workers they need.
Fiscal stimulus will only exacerbate the labor shortage. Passage of the tax-cut package seems likely to occur this month, even if we don’t know precisely what compromises will be reached in conference, and some early effects may become visible within the first quarter. Economic growth will be buttressed by this fiscal stimulus and the scarcity of labor will worsen. Indeed, some Fed officials have judiciously hinted that the stimulus being contemplated could lead to faster rate hikes.
Investors seem to be responding far more to the improving prospects for increased profits than to the risk of faster inflation, even though the two will come as a package deal. As each hurdle in the process for passing a fiscal package has been overcome, the equity market has rallied strongly, while the bond market has retreated only slightly. This inconsistency cannot be sustained. If the stock market’s wishes are realized, so will the bond market’s nightmares.
Moreover, investors seem to be dismissing out of hand any consideration that inflation pressures will emerge even without the fiscal stimulus that now appears to be coming. This seems remarkably short-sighted. It is our judgment that the fiscal legislation will support additional gains in the equity market, while the bond market remains highly vulnerable to the tightening labor market that will be reinforced by fiscal stimulus.
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Max Berley at email@example.com