The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.
This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.
There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail.
Last week, Janet Yellen’s Congressional testimony was studiously unchanged from the FOMC’s guidance just before election day. US rates will very likely rise by 0.25 per cent on 14 December, but the upward path after that will be gradual and dependent on economic developments.
In contrast to the Fed’s language when the FOMC raised rates a year ago, there has been no indication this time that they intend to set monetary policy on an auto-pilot aimed towards rapid “normalisation”.
Furthermore, the backdrop for US and global economic activity seems much more robust than a year ago, when China and the US were both slowing markedly, and the markets were fearful of a sudden devaluation of the renminbi. This means that higher US rates look more appropriate than they did previously.
The graph shows the “nowcasts” for economic activity since early 2015. It is clear that the US and global economies are currently growing about one percentage point more rapidly than they were when the Fed announced its first rate rise in December 2015. Markets can therefore absorb the next stage of tighter US monetary policy much more readily than last year.
But what about the longer term danger of a hawkish monetary shock from the Fed over the next year or two? The markets have now priced US short rates at 1 per cent at the end of 2017, and 1.4 per cent at the end of 2018. On both horizons, the FOMC’s dot plot continues to suggest that the Fed expects rates to be higher than than the markets expect, though the gap has narrowed a bit since the Trump victory.
With growth and inflation both rising, there have been some signs of a shift towards less dovishness among FOMC officials. Vice Chair Stanley Fischer, who was an outspoken hawk last year, warned recently that US interest rates might once again need to diverge from the international norm, especially if US economic growth begins to strengthen.
And James Bullard, until recently at the dovish end of the FOMC’s dot plot, has said that the election breaks political gridlock in Washington. Markets assumed this meant that fiscal stimulus could represent a “regime change” that might necessitate higher equilibrium real rates in the US, though he did not say so explicitly.
The question, though, is whether the Trump administration would seek to prevent the Fed from reacting to fiscal stimulus in the normal way by raising interest rates. Several commentators, including ex-FOMC member Narayana Kocherlokota, have suggested that the new “populist” administration may well object to higher interest rates, in much the same way that the Nixon administration did when Arthur Burns was the beleaguered Federal Reserve Chairman in the early 1970s.
But the meaning of “populism” may have changed in the field of monetary policy. The President-elect himself has been extremely inconsistent about interest rates. He suggested during the campaign that he was in favour of low rates, and said that he believed Janet Yellen was doing a good job. At other times, however, he said that Ms Yellen was a political stooge who had created a financial bubble to help the Democrats, and that higher rates were needed to control inflation and help savers.
The White House will be able to nominate newcomers to both the Fed Chair and Vice Chair positions in the next 18 months. Two Board of Governors appointments are scheduled to be filled immediately – presumably with the main candidates for eventual promotion to the role of Chair in 2018. A determined President could therefore effectively change the Fed leadership fairly quickly.
If Mr Trump has shown any consistency on this subject, it is that he thinks that a Republican should replace Ms Yellen as Fed Chair in 2018. The market has therefore been contemplating several “respectable” Republican names, including John Taylor, Gregory Mankiw and Glenn Hubbard. But each of these would be likely to adopt a somewhat more hawkish posture than Janet Yellen to monetary policy.
Furthermore, the Republican caucuses in Congress, and the Trump team of economic advisers, all seem to lean to towards less quantitative easing, and a more rules-based approach to monetary policy, than has been the case under the dovish leadership of Bernanke and Yellen. Vice President-elect Pence is a monetary hawk, and even a fan of the Gold Standard. Congressional Republicans do, however, generally believe that the Fed should be “audited” by the Government Accountability Office, which could provide an opening for future politicisation.
Of course, it is entirely possible that the President-elect intends to populate the Fed with poorly qualified candidates who will be expected to do his bidding. But as the astute Tim Duy points out here, it is unwise to jump to conclusions on this. It seems just as likely that the new Fed will actually turn out to be more hawkish than the old one, in which case an adverse monetary shock could be on the horizon in 2017.
It is clear that the markets will be very sensitive to the first Trump appointments to the Fed, due to be announced soon after Inauguration Day.