Based on what he said during his campaign and acceptance speech, President Donald Trump is widely expected to deploy sizable fiscal stimulus, by getting Congress to approve a large-scale infrastructure investment programme alongside major cuts to personal income and corporate taxes, all financed by large increases in the budget deficit. In addition, a simplified tax code and a rollback of regulations in various industries are expected to be part of the overall package.
This policy mix is not unique to Trump and his economic advisers. Prominent economists on the left like Paul Krugman and Larry Summers have been arguing for years that, in light of anaemic economic recovery, record low interest rates and the widely acknowledged need to upgrade and expand US infrastructure, the government would do well to borrow and spend more. For their part, Republicans have been calling for lower taxes and a rollback of post-financial crisis regulations as a way of spurring private sector investment and growth. Recently, the IMF came out in favour of a three-pronged approach – accommodative monetary policy, proactive fiscal policy and structural reforms – as the most assured way of getting the world economy onto a more sustainable growth trajectory.
Commentators have complained for years that monetary policy is ‘the only game in town’ and is increasingly overburdened. Stanley Fischer, vice chairman of the Federal Reserve, recently expressed cautious optimism that boosting investment in US infrastructure could relieve some of the pressure on the central bank. Even though the Fed had originally envisaged four rate hikes in 2016, it felt – rightly or wrongly – boxed in and unable to proceed for fear of tipping the economy back into disinflation. Arguably, with a major fiscal stimulus, it could now raise rates more comfortably.
This narrative is logical and internally consistent, with a non-negligible chance of success. But from a monetary policy perspective, there are three key risks to this benign scenario.
The first risk has to do with inflation expectations becoming ‘unanchored’, necessitating a much more forceful monetary tightening by the Fed. While market-based indicators of inflation expectations have already edged up, there is as yet no evidence that economic agents in the real economy – households and corporations – have started to plan for higher inflation. If and when this happens, the Fed will have no choice but to get ahead of the curve, raising interest rates faster and in potentially larger increments. What might trigger such a scenario? In his recent paper, the economist Andrew Smithers has offered a compelling analysis of why at this late stage in the recovery the US economy may simply not have sufficient slack to absorb a large fiscal stimulus without generating inflationary pressures.
Also, one must keep in mind the sheer amount of money that has been printed by the Fed during its multiple rounds of quantitative easing: as the economist Richard Koo has pointed out, the Fed has created excess reserves of $2.3 trillion, which is almost 17 times statutory reserves. In other words, if and when borrowing demand comes back and banks decide to expand their loan books, the potential growth in lending and money supply could easily add more fuel to the fire. Of course, the Fed can deploy three counter-measures: raise rates on reserves, sell some government bonds back into the market and raise statutory reserve levels. But in the presence of ‘unanchored’ inflation expectations and an overheating economy, there will be a very real risk of disruptive and disorderly moves in the government bond yield curve.
Politicizing the central bank
The second risk has to do with central bank independence. The Fed already found itself on the receiving end of some very harsh and unprecedented criticism from Donald Trump during the campaign. If and when it has to make difficult choices on monetary policy, with implications for bond yields and the currency, the Fed is likely to find itself in a tight spot politically. One does not have to be a fervent believer in central bank independence to see how undermining it against the backdrop of increasing inflationary pressures and an overheating economy would be the absolute worst time to do so.
The third risk has to do with excessive strength in the US dollar. There are already similarities with what transpired in the United States during the 1980s. At the time, the investor George Soros described US policy as Reagan’s ‘imperial circle’: loose fiscal policy to accommodate supply-side tax cuts and increased spending on the military, coupled with tight monetary policy, resulting in a much stronger currency and a growing current account deficit, as the US economy kept sucking in both goods and capital from the rest of the world.
The resulting tensions were eventually resolved through the Plaza Accord, which rang the death knell for Japan’s post-war economic development model and eventually led to its two ‘lost decades’. Similarly, Germany had its own version of the ‘imperial circle’ after re-unification, with loose fiscal policy and tight monetary policy boosting the Deutschmark and eventually resulting in the collapse of the Exchange Rate Mechanism in 1992. A stronger dollar has already tempered the Fed’s appetite for rate increases in 2016. How far might the US currency soar under President Trump, and what might be the endgame this time? And who might end up as collateral damage?
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