FOMC unimpressed by Trumphoria

Nick Stamenkovic - 15 December 2016

Wall Street has marked its growth and inflation forecasts higher since the election of president Trump, but the Fed has not. Despite unchanged growth and inflation projections, FOMC members raised the profile of the “dot plot” for the first time since December 2014. The median estimate for the funds rate for 2017 was raised from 1.1% to 1.4%, pointing to three rate hikes next year, one more than indicated in September. A further three modest rate moves are envisaged for 2018. Indeed, the dots of individual FOMC members are more dispersed than previously, suggesting more members regard a higher profile for funds rate as warranted. After 2 years of watching the Fed shift its rate view towards the market curve, finally the market curve has shifted towards the Fed.

Clearly the Fed is mindful of a policy shift towards reflation in a Trump administration but is unsure about the impact on monetary policy. Witness the comments from Fed Chair Yellen’s latest press conference, signalling a wait-and-see stance. At the same time, Yellen acknowledged that some, but not all, FOMC members are factoring in a more expansionary fiscal stance over the medium-term.

Trump’s fiscal plans focus on tax cuts, increased infrastructure spending and reduced regulation. A further stimulus to an already strengthening US economy poses upside risks to inflation over the medium-term. This would necessitate a more aggressive Fed posture, reinforcing current bearish Treasury market sentiment. Still, real interest rates would remain low by historic standards, highlighting a continued monetary accommodation.

The interaction of monetary and fiscal policy will be a key driver of the trajectory of US rates in the next few years. A more expansionary budgetary stance would provide a challenge to the Fed’s current gradualist stance as it fights increasing inflation pressures. Yet at the same time the Fed will be mindful of not tipping the US economy into recession, threatening increased political tensions with the new US president.  

Failure to deliver on the fiscal front with tax cuts and government spending increases watered down by mainstream Republicans would arguably lessen pressure on the Fed. The US government bond market would likely see a relief rally as US rate expectations decline, taking the shine off the US dollar. Wall Street would be disappointed by any signs that tax reforms will be delayed, crucial for earnings expectations. 

Next year four members step down from the FOMC: well-known hawks Loretta Mester, Eric Rosengren, Esther George and to a lesser extent James Bullard. Replacements of Robert Kaplan, Neel Kashkari, Patrick Harker and Charles Evans are arguably more dovish. Still, the degree of monetary tightening in this cycle is likely to be driven by the trio of Yellen, Fischer and Dudley rather than the diversity of regional FOMC members.

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