Daily Times

The sugar rush that President Donald Trump’s tax cuts and fiscal stimulus injected into the US economy poses a quandary for the Federal Reserve and its chairman, Jerome Powell, in their campaign to raise interest rates: where and when to stop?

Investors and economists at this week’s Reuters Global Investment 2019 Outlook Summit agree that more rate hikes are needed.

But they said overtightening could backfire as the economic benefits from Trump’s policies wear thin, perhaps exacerbating the surging market volatility that reared its head in October.

Given the Fed’s “dual mandate” of price stability and full employment, “it would be very hard for them to justify pausing when by almost any measure, interest rates are still below neutral,” said Scott Minerd, global chief investment officer at Guggenheim Partners in New York, which invests $265 billion.

“The question is: Where is the neutral rate?” he said.

In December 2015, the Fed ended seven years of near-zero interest rates that followed the financial crisis, gradually pushing its benchmark federal funds rate to the current 2 to 2.25 percent.

Some of that increase has coincided with the Fed’s campaign to start shrinking its balance sheet, which quintupled in size after the crisis.

“The Fed is doing the right thing,” said Byron Wien, vice chairman at Blackstone Private Wealth Solutions Group. “The Fed did the wrong thing by keeping rates low for too long.”

Policy Mistake?

Summit speakers expect another 0.25 percentage point rate hike when the Fed meets in December, and one to three additional hikes in 2019.

But they worry that the Fed’s focus on known economic and market data could leave it behind the curve when economic growth starts to meaningfully, and inevitably, slow or end.

“I don’t think they’re doing anything wrong, but that doesn’t mean they’re not at risk of making a policy mistake,” said Joachim Fels, global economic adviser at Pacific Investment Management Co in Newport Beach, California. “The biggest risk is the Fed moving too fast. … Nobody really knows where that neutral rate of interest is.”

Fels’ firm invests $1.72 trillion. He expects a rate hike in December and two more in 2019.

The Fed likely can afford to act gradually.

With US unemployment at a 49-year low and the economy expanding at a 3.5 percent annual rate, investors and economists are not expecting a slowdown or downturn before 2020.

But they worry that neither the Fed nor lawmakers might have the tools to fight the inevitable, with Trump’s trade policies a key potential downside risk and the federal budget deficit expected to balloon.

The deficit was $779 billion in the recently completed 2018 fiscal year, up from $438 billion three years earlier, according to the Congressional Budget Office https://www.cbo.gov/system/files?file=2018-11/54647-MBR.pdf.

“If you look at all past cycles, has the Fed ever been able to accomplish a soft landing? I don’t think that’s true,” said Monica Erickson, a bond manager who helps invest more than $120 billion at DoubleLine Capital LP in Los Angeles.

“Real rates are still very low, so you really need to bring them up, but if you bring them up there is a risk of cutting off the party,” she added.

No One-Way Street

Minerd expressed concern the Fed might be too slow to recognize when its policies might be inducing a recession, reaching the height of its tightening just as “fiscal drag” begins creeping into the economy, which he expects in 2020.

Not that recession is always a bad thing.

Recessions are “natural and necessary in a capitalist system,” Minerd said. “By flushing out excesses you avoid malinvestment, allowing inflation to become entrenched, and other policy errors, and then it gives you a foundation to build a new expansion.”

Powell has sometimes rattled markets with hawkish language.

On Wednesday, Powell said the economy looked “really strong,” but he cited caution over the longer-term trend due to slowing growth abroad and because the boost from the tax cuts and spending increases will “wear off over time.”

The Fed chairman has drawn frequent criticism from Trump, who fears that high rates could harm the economy.

Powell “will gradually tone down the language, but it will be in response to the economy and to the data, not in response to Trump,” said Fels.

Published in Daily Times, November 17^th 2018.