Federal Reserve officials do not seem to be buying what tax cut advocates are selling, namely that economic growth will offset the proposed rate reductions.
Even with the sharp uptick in 2018 GDP projections, central bank policymakers view gains in coming years as muted and more in line with the post-financial crisis trend. Following its meeting this week, the Fed pushed its estimate for 2018 from 2.1 percent to 2.5 percent, but then said the level would fall to 2.1 percent and 2 percent in the following years.
President Donald Trump and his team of economic advisors, along with the Republican congressional leadership, have pitched the tax plan largely on hopes that it would generate economic gains of 3 percent and upward.
The Fed projections don’t follow that script, setting up a potential conflict between policy projections and conditions in the real economy.
“It’s clear from [the estimates released Wednesday] that the Fed doesn’t think that Trump’s tax cuts will give a substantial long-run boost to growth. This is about as close as the Fed will get to saying the policy was mistimed,” said Luke Bartholomew, investment strategist at Aberdeen Standard Investments.
Indeed, critics of the tax reform plan have attacked it on three fronts: that benefits are tilted toward high earners, that it will explode the budget deficit, and that with the economy recovering on its own and near full employment, tax cuts will have limited benefit and could stoke inflation.
Supporters counter that the moves will free up trapped money, encouraging business investment and consumer spending that will lift the economy out of its subtrend growth experienced during the recovery.
So far, the trend seems to be on their side, with the Fed and others increasing their GDP projections and retail sales from December well ahead of Wall Street estimates, even with tax cuts not yet approved. The Fed’s own Atlanta branch now sees fourth-quarter GDP rising to 3.3 percent, which would bring the average of the year’s final three quarters to 3.23 percent and the full-year average to 2.7 percent, well above the 2.1 percent during the previous recovery years.
From the policymaking Federal Open Market Committee’s perspective, the question will be whether it will need to step in to put the brakes on runaway growth or will it be able to continue its gradualist approach to policy normalization. The FOMC this week voted to hike the central bank’s benchmark interest rate target a quarter point, the fifth such move since December 2015.
The perils of ‘political sensitivity’
Fed Chair Janet Yellen said she and her colleagues have been keeping tabs on the progress of tax policy and in fact have been incorporating developments into their forecasts all year. But the boost to the 2018 estimate, she said, is not due solely to the prospects for tax cuts.
“There is considerable uncertainty about the impacts, and that will have to be monitored over time,” the outgoing chair said at her final post-meeting news conference Wednesday.
However, some on Wall Street think the Fed is being overly cautious.
Jan Hatzius, chief economist at Goldman Sachs, contends the Fed will be forced into more aggressive policy tightening than current forecasts indicate. According to the quarterly summary of economic projections released this week, officials are eyeing three interest rate hikes in 2018, followed by two apiece the following two years.
“We think the monetary policy projections may be lagging the economic projections, perhaps in part due to political sensitivity,” Hatzius said in a note to clients.
Officials may be unwilling, that is, to mark up their growth expectations too aggressively for fear of looking like they are endorsing Congress’s fiscal policy. Yellen has worked assiduously to keep out of the intense fray on Capitol Hill.
What’s emerged has been a disparate level of expectations for the course of Fed policy.
Traders in the fed funds futures market anticipate two hikes next year, the Fed itself has pointed to three, while Hatzius and a growing number of his peers expect four. Economists Krishna Guha at Evercore ISI, Paul Ashworth at Capital Economics and Brian Coulton at Fitch Ratings each said after the meeting that they see four hikes ahead.
Mike Loewengart, vice president of investment strategy at E-Trade, predicted “this is a battle the Fed will be fighting well into next year,” when Jerome Powell likely takes Yellen’s position as chairman.
“Typically you don’t have monetary tightening occurring when the government is on the cusp of accommodative fiscal easing through tax reform,” Loewengart said.
For the 2018 group of Fed voters, the calculus will be weighing between economic growth, inflation and the upward pressure of aggressive growth policies on Capitol Hill.
“On one hand the Fed has upgraded its forecast of GDP growth and unemployment, on the other inflation just won’t budge. This is the conundrum that Powell inherits as they aim for three gradual increases in 2018,” Loewengart said. “Not an easy task by any means, especially with two Fed officials refusing to buy into the ‘rock solid economy’ story. It may also be more complex than many believe.”