Headwinds from the Fed Offset by Fiscal Tailwinds
One More Gradual Step
Today, the Federal Reserve announced a 25 basis point (bps) increase in interest rates. This marks the sixth increase in interest rates since the Fed began raising rates in 2015, and the first of three interest-rate hikes that were anticipated for 2018 in the projections of December 2017 from the Federal Reserve (Fed). In addition, at today’s press conference, Chairman Jerome Powell stated that the economic outlook has strengthened, and that the Fed now expects to tighten further in 2019.
With recent months showing an underlying inflation pace around 3% in annualized terms and labor markets solid, the Fed has the necessary conditions in place to signal a continuance in its gradual pace of operations.
Figure 1: The Federal Reserve’s Gradual Pace of Normalization
Sources: Thomson Reuters Datastream, New York Life Investments, as of 3/21/18.
Less Supportive Monetary Policy
The Fed continues to unwind its historically unprecedented policy stimulus. The Fed ceased purchasing securities over three years ago, began increasing the Fed Funds Rate one year later, and last September, began to reduce the size of the balance sheet by reinvesting only a portion of the proceeds from coupon payments and principal repayments on matured bonds. The reduction, in combination with additional rate hikes, is beginning to shift monetary conditions.
As a result, short-term interest rates have risen to new post-crisis highs, and corporate bond yields and mortgage rates have recently risen as well. Higher rates can be restrictive for growth, as they increase borrowing costs and reduce profitability. However, other factors – the fact that long-term bond yields have not risen as fast as short-term rates and the dollar has declined over the recent year – have acted to offset the impact of rising rates, and thus, kept financial conditions loose. In fact, financial conditions are looser today than when the Fed first began in 2015.
Figure 2: Financial Conditions Remain Very Supportive of Economic Growth
National Financial Conditions Index (12/31/04 – 3/9/18)
Sources: Thomson Reuters Datastream, New York Life Investments, as of 3/9/18. The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt, and equity markets and the traditional and “shadow” banking systems. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Headwinds and Tailwinds: The Better of the Two?
In addition, the recent shift in fiscal policy is significant. In December, Congress passed sweeping tax reform. In February, Congress passed a budget deal for 2018-19 that raised federal spending caps by a total of $300B. In total, this fiscal policy shift may boost gross domestic product (GDP) by 1.1% in 2018 and 1.6% in 2019.1
We estimate that the slight tightening of financial conditions since November 2017, as bond yields have risen, represents a headwind for GDP growth of about 0.3% on a 1-2-year horizon. In comparison, however, is the estimated fiscal boost to GDP from tax reform and the budget deal combine to form a tailwind worth 1.4% of GDP on average for 2018-19.
At this point, the tailwinds from the fiscal policy boost are more than four times as strong as the headwinds from rising interest rates.
Tailwinds Outweigh Headwinds
Source: New York Life Investments, as of 3/21/18. SAS Group estimates based on historical relationship between financial conditions and GDP growth and, for the Hutchins fiscal impact measure, the Brookings Institution. The GDP impact is estimated based on what is known today and is projected for 2018-19.
Interest rates are higher, but financial conditions remain supportive, and the recent shift in fiscal policy provides material tailwinds for the economy in 2018-19.
Looking ahead, the expansion is not yet in need of rapid Fed tightening, but investors shouldn’t discount the degree of upside for the anticipated rate path. Comments by Chairman Powell indicate an optimistic view of the growth prospects for 2018-19, with the Fed continuing to closely monitor inflation trends. The Fed could choose to take a less gradual approach.
1. We estimate the GDP impact of fiscal policy using the so-called Hutchins Center Fiscal Impact Measure, which uses the legislated changes in tax revenues and federal spending as inputs. Source: Hutchins Center on Fiscal and Monetary Policy at Brookings.
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