The Federal reserve met market expectations yesterday and raised the target for the benchmark Fed Funds rate by 0.25% to 0.5-0.75%, and market consensus is for the path to continue upwards with two-three more hikes priced in for 2017, very much in line with the Fed’s own forecasts. But the markets may be getting ahead of themselves.
As much as recent economic data releases seem to indicate a slow improvement in the US economy, nothing can change the fact that years of artificial credit expansion has pushed asset markets across the globe well into bubble territory. Stock markets, described colourfully but correctly by Donald Trump during the campaign as a ‘big, fat, ugly bubble’, have been hitting new all-time highs since the election, fuelled by the very same people who told us Trump would be a disaster. Nothing can seemingly change the bullish mood.
Short term the party may continue, but the collapse of the bubble will eventually occur. For now, we expect little change in rhetoric from the Fed, but even if the markets are naïve enough to believe the talk of recovery, the Fed cannot allow a significant rise in neither short or long term rates. An economy servicing $14tn of mortgage debt, $1tn of auto debt and $1.2tn of student debt can survive higher rates no more than an administration needing to fund a deficit which currently stands at $600bn, before Trump starts adding to it. Trump ran on a platform of unfunded tax cuts and increased infrastructure spending. The tax cuts alone will, according to the Tax Policy Center, add a whopping $7.2tn to the Federal debt over the next decade (current on-balance sheet debt stands at just under $20tn). His so far sketchy infrastructure investment plans are supposed to amount to $550bn and another pledge is to rebuild the ‘depleted’ US military, which apparently goes wanting despite gobbling up almost $600bn, or more than half of federal discretionary spending. Federal debt stands just under $20tn and has more than doubled under Obama. With the proposed policies, Trump would do well to maintain that growth rate, which means $25bn should be easily reached over the next 4 years.
Change at the Fed could happen under Trump. He has earlier called out the Fed as doing a ‘political job’ by keeping interest rates low and even called for audit of the central bank. Though he has indicated that he will replace Janet Yellen, it will only happen when her term expires in January 2018, though he can replace some board members before then. But any replacements would be highly unlikely to veer much from the current path anyway.
The Fed has for a long time, despite its rhetoric, been well aware that the US economy is unable to withstand any meaningful increase in interest rates. The talk of recovery may continue, but after the election produced the ‘wrong’ outcome, the pressure to keep up appearance of recovery may dissipate slightly. Counteracting that will be the need to maintain a guise of inflation targeting, so expectations of rising inflation may keep the rhetoric hawkish. The markets have quickly concluded that a Trump presidency means higher inflation, and correctly so. Fiscal expansion and the perceived Trump anti-trade bias is inflationary. We believe that inflation is currently under-reported, but if official inflation figures start exceeding the Fed’s target of 2%, it is very possible that the target will be moved upwards. No matter what, the policy follow-through will remain elusive. Eventually faltering economic growth or the need to monetise government deficits will force another round of rate cuts and quantitative easing.