It's NFL Combine week, the time when college football prospects have an opportunity to showcase their talents for scouts across the league. Quarterbacks are one of the most watched groups because they represent the future leadership of NFL teams. They are tested for speed, throwing accuracy and overall football handling skills. Mismanaging a simple handoff can deter scouts' interest because turning over the football loses games.
We are in the early stages of the handoff between monetary and fiscal policy makers. Just like the fumbled handoff that leads to the winning touchdown, getting this wrong could have a deleterious effect on the economy's performance for years to come.
Monetary policy is controlled by the Federal Reserve. This policy has to do with the availability of capital in the financial system and the cost of that capital. They alter policy by setting short-term interest rates, and more recently by changing the size of their balance sheet. The Fed's efforts are meant to control inflation as the economy's growth rate either heats up or cools.
Fiscal policy is managed by the federal government. The administration and Congress make policy decisions to affect the way the government raises revenue (i.e., taxes) and spends money, which can also affect the growth rate of the economy.
This handoff between monetary and fiscal policy has been a long time coming. As the Federal Reserve bank raises short-term interest rates and reduces the size of its balance sheet (remember “quantitative easing,” the action taken by the Fed through which it purchased Treasury bonds and mortgage-backed securities to add cash to the banking system), it is eliminating monetary stimulus from the system.
Last week the new chairman of the Federal Reserve, Jerome (Jay) Powell, gave his first testimony in front of Congress since being confirmed by the Senate. He noted that the core measure of inflation used by the Fed was 1.5% in 2017, below its 2% target. However, he said, “We continue to view some of the shortfall in inflation last year as likely reflecting transitory influences that we do not expect will repeat…” He is indicating that the Fed believes inflation will likely rise throughout 2018, providing cover for it to continue raising short-term interest rates throughout the year. Acknowledging the handoff to fiscal policy makers, he noted that “fiscal policy is becoming more stimulative.” He went on to suggest that this stimulus has the potential to lift inflation, which should “stabilize around the FOMC's 2% objective over the medium term.” In the Fed's parlance, medium term is probably the next couple of years.
Chairman Powell noted that the interest rate increases (the Fed Funds rate is now targeting a range of 1.25% to 1.5%) and the “balance sheet normalization program to reduce the Fed's securities holdings” reflect the Committee's view that “gradually reducing monetary policy accommodation will sustain a strong labor market while fostering a return of inflation to 2%.”
Chairman Powell was making a statement to congressional leaders (i.e., fiscal policy makers) that given the current economic environment, he is comfortable with the handoff to them. However, during the question and answer session, he revealed a concern we share about the new fiscal policies. He was asked more than once about the sustainability of the federal government's deficit. He indicated that with the economy growing nearer 3% and unemployment approaching 4%, the Federal government should not be running a $1 trillion deficit as expected in 2018. However, he did say that the deficit isn't an issue right now; rather, it is a long-term problem to continue to add to the budget deficit at this rate. He is one in a long line of Fed chairs who have said as much to Congress. Powell said that the cost of the deficit, as interest rates rise, will continue to go up and use a larger portion of the government's budget.
That interchange with the senators was like saying, “I'm handing you the ball; don't drop it.”
Fiscal stimulus is coming in a number of different forms, some having potential benefits, some that could be detrimental. First, the benefits.
The administration and Congress passed significant tax reform at the end of 2017. The permanent reduction in corporate taxes should lead to greater business investment and some higher wages, and the reduction in personal taxes may lead to higher consumption. These are all stimulative effects of the new tax policy.
In addition, the federal register, where new regulations are listed, shows a substantial decline in the amount of new regulation taking place. As many companies have reported earnings for the fourth quarter of 2017, they have guided earnings higher in 2018, partly because they are more confident about the environment in which they have to operate their businesses. Greater regulation creates uncertainty for the business environment, and while regulations haven't been eliminated at the pace described by the administration, there is little new regulation taking place.
While these policies suggest that the handoff from monetary to fiscal policy makers has benefits for economic growth, there is one more policy that has the potential to undo some of those benefits.
Last Thursday, President Trump suggested that he would entertain tariffs on steel and aluminum this week. In a tweet, he said, “When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win.” The problem with Twitter is it really doesn't provide the opportunity to discuss complex issues given the limited number of characters.
With this statement, the stock market lost ground as investors feared that trade may be the policy focus in the near term, just as health care was for more than half of last year. Not everyone agrees with the president's sentiment that “trade wars are good and easy to win.” The certainty that business managers were feeling as a result of fewer regulations and lower taxes could be harmed if the President Trump begins to unilaterally attack individual parts of the economy with tariffs as opposed to working through the trade agreement negotiating process. It could be that he is sending a message to negotiators that they better be serious about making progress or he may use his executive power. At this point it is too early to tell. Still, markets don't like policy uncertainty, no more than quarterbacks like running backs who don't follow the playbook.
Overall, the handoff from monetary to fiscal policy makers is in its early stages and mostly has just begun here in the U.S. With a similar handoff taking place in Europe and Japan, we can expect more volatility from markets. Monetary policy makers, central bankers, understand that communication is everything when it comes to the effectiveness of policy. Government officials may not be as clear, adding to investors' uncertainty. For our part, we will watch what they do, more than what they say, to determine our best course of action.