Making America Neutral Again

Making America Neutral Again

The election of President Donald Trump and his vow of fiscal stimulus as well as the threat of a rough election in France have dulled the Fed’s decade-long hold of the financial news. But the Fed’s policies still count.

One of the most important—though ignored—shifts since the US election has been the Fed’s stance on fiscal policy. Instead of waiting for the political uncertainty to resolve itself, the Fed has tightened its policy stance and pledged to keep doing so. There are several reasons why it has made this promise. Some of the most important lead straight back to the Trump administration’s goal to “Make America Great Again.”

If all goes as planned, the Trump administration is set to reduce taxes and regulation while increasing fiscal spending. This should increase the growth rate and push inflation higher. Then the Fed will soon increase the level of the neutral interest rate. That’s the policy rate that, in theory, will neither help nor halt economic growth.

In fairness, the US economy was already on solid ground before the current administration took office. It is the trajectory and possible future catalysts for the economy that have changed. This is important because the potential for accelerating economic growth gives the Fed a chance to “normalize” policy—or at least begin the process—faster than previously expected.

But it also introduces the possibility of conflict between policies. The Fed is tasked with keeping inflation in check and employment at its highest. With both objectives close to being achieved, a boost in economic growth might force the Fed’s hand. This could cause it to tighten more quickly, which would blunt some of the efficacy of the administration’s policy.

Enter the “neutral rate” construct. The so-called natural rate of interest is one of the more interesting, though controversial, metrics for explaining the stance of monetary policy. It is a sign of whether the Fed's policies are dovish or hawkish and by how much. It is very hard to measure.

For now, the neutral rate holds more importance than it previously did. This is due to the Fed’s shifting away from its accommodative stance. This opens the Fed up to criticism and dissection of nuances in its calculations that otherwise would not matter. The San Francisco Fed publishes one of the more popular measures of the neutral rate, and a strange thing happened recently—it fell to 0%.

In a recent speech, Chair Yellen made it clear that “with labor market conditions now in the vicinity of our maximum employment objective, the Committee considers it appropriate to move toward a neutral policy stance.”

In Fed speak, neutral policy is governed by its estimate of where the neutral rate is placed. Chair Yellen said, earlier in the same speech, that the neutral rate was estimated to be close to 0%. She was saying that some tightening is currently needed for the Fed to be okay with its outlook for the economy.

This brings up another issue: the pace at which the Fed will hike interest rates. The Fed wants to remain at neutral (with the location of neutral moving lower at the moment). But the ability of the Fed to hike is at the whim of fiscal stimulus. Put simply, the Fed is no longer in control of its own fate. It has closely tied its policy to that of the Trump administration.

The Trump administration will soon detail its tax reforms. The reaction of inflation and growth expectations will have a major impact on the Federal Reserve and the pace of the tightening cycle. The Fed has vowed to tighten more this year. It has even begun to talk about allowing some of the last pieces of quantitative easing to slowly dissipate. This should not be mixed with Fed belief in the Trump administration’s policies. The belief in its tightening path is a tacit support of fiscal policy’s ability to reaccelerate the economy.

Granted, a 15% corporate tax rate is unlikely to pass muster. But any positive change on the corporate and individual side should have a positive effect on the economy and the neutral rate. (Although, the extent of this effect is anyone's guess.) Despite the magnitude, however, this is a positive for the overall economy and should not be dismissed.

With the Fed shifting to a neutral stance, the tax proposal will have a direct impact on how monetary policy is carried out. If the tax proposals begin to move the neutral rate up once again, the Fed is likely to counteract it to remain neutral. In any event, the Fed’s tightening and the Trump tax cuts are deeply linked. And it will be nearly impossible to undo the link.