Fed forecasting is surprisingly easy, despite the sturm und drang of the talking heads. It’s a matter of considering what we know and what we don’t know, and observing the indications and warnings that presage the unknown.
What we know is that the Fed is biased toward rate increases as long as the economy is growing. This is because the Fed needs to raise rates to 3.25% before the next recession in order to cut them back to 0% when the recession hits; approximately the amount of cutting needed to pull the economy out of recession.
The Fed is unlikely to reach this goal without either causing a recession, or facing one anyway, but they will try.
Simply because the Fed wants to cut rates does not mean they will. The entire course of 2015 and 2016 was a case study of not being able to raise rates more, despite wanting to. What stands in the way of rate hikes? There are four hurdles, which can arrive singly or in combinations.
These are deflation, job losses, technical recession, and tighter financial conditions from sources other than rate hikes. The last hurdle includes a number of conditions, such as global contagion or a stock market correction.
There are many examples to illustrate this. The Fed was on track to raise rates in September 2015, but did not do so because of the Chinese devaluation and US stock market correction in August. The Fed was on track to raise rates in March 2016, but did not do so because of the stock market correction from 2 January to 10 February 2016.
The Fed also did not raise rates in September or November 2016 because of the US election, but that’s a one-off constraint on policy. The Fed is highly political, protestations to the contrary notwithstanding.
So, forecasting the Fed is straightforward. If you do not see any of these hurdles, the Fed will raise rates every March, June, September, and December from now until the end of 2019. If you do see these hurdles in strong form, the Fed will not raise rates. Insiders call this a ‘pause’, and that’s a good way to understand it.
As of now, none of the pause indicators are flashing red, so the Fed will raise rates in March. That rate hike is not fully discounted in the market yet. The Fed’s job from now until March will be to communicate the likelihood of a rate hike through speeches, leaks, and various statements. This will be a headwind for gold, and it should not be surprising if gold trades lower in the next few months.
What about Trump? The Fed has not changed its policy bias as of now because they simply do not have enough information about Trump’s actual policies. (Ignore the ‘dots’ from the Federal Open Market Committee [FOMC] meeting in December. They are nothing more than the median of 17 blind guesses forced upon the FOMC participants.)
But using causal inference (also known as Bayes Theorem), our estimate is that Fed chair Janet Yellen expects Trump’s policy to be stimulative because of the combination of tax cuts, reduced regulation, and higher spending on defence and critical infrastructure. This tips the Fed’s bias even more strongly toward tightening, and creates a strong case for a rate hike in March.
I’ve written a lot about helicopter money and about how it’s one of the ‘tools’ the Fed has in its toolkit. But, at least for now, it doesn’t appear that the Fed will use helicopter money to accommodate Trump’s stimulus.
That’s primarily because of their misplaced reliance on the Phillips Curve, which posits that lower unemployment means higher inflation. There’s also the fact that monetary policy works with a lag.
The Fed does not want to get behind the curve on inflation. Yellen will lean-in against Trump stimulus with rate hikes. Besides, Yellen personally dislikes Trump and is not out to do him any favours.
But beyond that, there’s good reason to believe that the Trump stimulus will not arrive as many expect. Congress is already pushing back against tax cuts that are not revenue neutral. This means tax cuts have to be offset with either spending cuts or other tax increases, thereby diluting the stimulative impact.
There’s no evidence for a Laffer Curve effect that will make up for tax cuts with higher growth, despite claims. The most stimulative tax cut would be a reduction in social security taxes (this helps poorer people with a higher marginal propensity to consume), but that is not on the table.
Reductions in regulation can be stimulative, but they take months to implement and even longer to affect investment decisions. Spending increases will also be held in check because the US has US$20 trillion in debt and a debt-to-GDP ratio of 104%. This is already well in the danger zone of 90% or higher identified by Kenneth Rogoff and Carmen Reinhardt. Congress will balk at busting budget caps.
Even if Congress goes along with more spending, after eight years of growth the economy is at the stage of diminished or negative marginal returns. Neo-Keynesian solutions work best, if at all, in the early stages of recovery, not the late stages. Further deficit spending will push the US toward the same debt-deficit death spiral already achieved in Greece.
In addition to the lack of stimulus from Trump’s tax, regulatory and fiscal policies, there may be additional headwinds to growth coming from Trump’s trade and foreign policies, especially as they relate to China. The Fed has given the prospect of a trade war little weight so far.
There are even more troubling global tremors coming from the US dollar shortage and a looming crisis in dollar-denominated emerging markets corporate debt. European banking problems are another wildcard.
This disjunction between the Fed’s (and the market’s) view of the Trump reflation trade and the reality of little or no stimulus in the pipeline will cause a head-on collision between perception and reality.
This collision will take place during springtime in the Northern Hemisphere.
At that point a technical recession or a violent stock market correction may occur. The Fed will be late to react, but either outcome will throw the Fed off its rate hike path once again. The Fed will be forced to ease by forward guidance; rate cuts are still some way off.
Still, markets will get the easing message, and gold will resume its long march higher. I expect the next several months as an excellent entry point for gold buyers before this next episode of Fed flip-flopping becomes apparent.
For Markets and Money, Australia