Sanguine US Fed waits on Republican fiscal policy decisions

By Arthur Kamp, investment economist at Sanlam Investments

The US Federal Reserve’s decision on 15 March 2017 to increase the target range for the federal funds rate by 0.25% to 0.75-1.0% was widely anticipated.

It is clear from the Federal Open Market Committee (FOMC) statement that the hike reflected the satisfaction of the Committee with the continued progress of the economy, notably the firmness of jobs growth amid a moderate medium-term GDP growth outlook.

Unemployment a risk to inflation

At 4.7% in February 2017, the US unemployment rate is, arguably, below the unemployment rate at which there is a risk of upward pressure on inflation – as suggested by the increase in the annual advance in US average hourly earnings since last year when the unemployment rate fell below 5%.

Credit extension has recovered

Further, US credit extension has also recovered from the slump induced by the global financial crisis.  Given historical relationships between the US unemployment rate (which the FOMC expects to decline further to 4.5% by Q4 2017), credit extension and the US federal funds target rate, it is not surprising the US Federal Reserve has continued to increase its policy rate.

The hiking path remains gradual

Note, the FOMC continues to signal a gradual interest rate hiking path. The median projection for the federal funds rate of FOMC participants shows an increase to 1.4% at end 2017, effectively signalling three interest rate hikes of 25bp each in total this year, followed by further increases to 2.1% and 3% at end 2018 and 2019 respectively. The latter is in line with the long-run estimate for the federal funds rate and the FOMC points out it’s relatively low compared with the history of recent decades.

Future fiscal policy creates significant uncertainty

Nonetheless, despite its current sanguine approach, the FOMC is careful to signal the ‘projected’ future course of its policy rate could be influenced by factors such as changes to US fiscal policy. Currently, there is a high degree of uncertainty around likely policy changes under a Republican administration. For example, it is not known to what extent revenue raising measures, including ‘border adjustments’ proposed by the House Republicans, will, if at all, claw back revenue losses from expected corporate tax cuts. Under border adjustment, imports would no longer be tax deductible, while export proceeds would not be viewed as taxable income. It is also not clear whether border adjustments would represent a breach of World Trade Organisation rules.

Neither is the extent of likely US tax cuts known, as yet. The same degree of uncertainty holds for infrastructure spending, which is likely to trigger expenditure cuts elsewhere.

It seems reasonable to argue, however, that there are binding constraints to the proposed fiscal policy expansion initiatives of President Trump and the Republican Party. The Republicans have a majority in both the House of Representatives and the Senate, but support for the President’s initial Budget proposals is not necessarily universal within the Party.

Is the US fiscus strong enough for expansion?

Importantly, too, the current fiscal position of the US is not sufficiently robust to allow for a large fiscal expansion programme, at least not in the absence of a meaningful lift in the potential GDP growth rate. If implemented, an anti-immigration stance and protectionist foreign trade agenda are likely to constrain the supply-side of the economy and run counter to excessively ambitious expansionary fiscal plans.

It is possible that mooted regulatory reform may remove some of the binding constraints to US GDP growth. That said deregulation is a lengthy process. Reducing and simplifying regulations could pay dividends in the long-run, but one doubts it will exert a strong impact in the near term.

Ultimately, US fiscal expansion could be significantly less extensive than initially envisaged by President Trump with House Republicans likely to be concerned over the implications for the Budget balance. Even so, the US Federal Reserve will be mindful of the possible inflation risk posed by an expansionary fiscal policy, especially if also accompanied by an increase in US trade protectionist measures against the backdrop of a low unemployment rate.

On balance, with medium-term inflation projected at around 2%, the Fed, at the very least, can be expected to continue ‘normalizing’ monetary policy. Meanwhile, the interest rate hiking cycle is expected to be modest, but upside risk lingers. This, in turn, implies risk to indebted emerging market economies running material macroeconomic imbalances, including South Africa.