Hearing Janet Yellen speak at the post-policy press conference, one would believe that the US economy is cruising along at just the right speed, with unemployment falling and inflation remaining under control. She says “my judgement is that we are on a good path to reaching our objectives,” sounding very different from the images of economic doom raised by Donald Trump during his campaign speeches. So much so, that many investors were waiting for a retaliatory tweet from the president-elect. The markets, meanwhile, reacted to the Federal Open Market Committee’s revised projection of three rate hikes in 2017, up from two, projected in the previous policy review in September. US equities reversed their rising trend, bonds slumped and the dollar hit new highs.
The Fed chairperson maintained that the committee had made only a modest shift from the earlier projected path of the federal funds rate and that possible changes in fiscal and other economic policies may have been incorporated into these projections. Yet, it was hard not to miss the change in language: While earlier, the forward guidance was always data-dependent, the Fed’s statement this time around reinforced the market’s belief that fiscal policy would become more expansionary under the Trump administration and inflation would harden in 2017.
Going by last years’ experience, however, there is plenty of room for the Federal Reserve to go back on its projection of three rate hikes in 2017. At the end of 2015, when the Fed had hiked rates for the first time since the crisis, it had also projected four quarter-point increases this year. In reality, there was only one actual quarter-point increase. This could imply that irrespective of the more hawkish interest rate projection, the actual path of the federal funds rate will be contingent upon incoming data releases and more so on Trump’s policies. Global economic realities also cannot be ignored by a hawkish Fed, especially when the rest of the world’s central banks are still in an easing mode.
Last time around, as the dollar began to rally, hurting US competitiveness, the Fed backed off from a tightening mode. This could happen again this year. With deflationary trends continuing in Europe and parts of Asia, the Fed cannot afford to keep driving up the dollar. And contrary to the comfortable picture presented by the Fed, data prints in the US do show some loss of economic momentum in the fourth quarter. The dot plot, which the Federal Reserve uses to signal its outlook on interest rates, need not be the last word on the Fed’s actual actions.
Yellen’s remark that fiscal stimulus is not “obviously needed to help us back to full employment” seems to reveal a desire to position herself in opposition to the Trump camp that has proposed tax cuts and spending increases as a way out of the economic quagmire. However, she was careful to hedge that statement by saying that she was not providing advice to the incoming administration. It seems unlikely that the Fed will choose to be in conflict with the new government. After all, both have the same objective of achieving low unemployment via steady economic growth. The problem arises when the stimulus results in higher inflation rather than growth.
Trump’s pick for treasury secretary, Steven Mnuchin, has said that his first priority would be to get the economy back to three to four per cent growth. Remember that the US economy has not grown at above three per cent in the last 10 years and productivity has stagnated. Fiscal stimulus alone may not be enough to drive up growth in this situation and could end up being inflationary. In a media interview, Mnuchin and Wilbur Ross (selected to be commerce secretary) have spelt out some of the policy priorities for the new government. They include areas such as tax reform (reduction in tax rates along with fewer deductions), renegotiation of trade treaties and regulatory reform to encourage more lending by banks. A well thought out plan has the potential to raise productivity and growth in the US economy. The Fed will have to keep guessing till the Trump programme is discussed in Congress and rolled out.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
