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Why US Fed risks turning into a villain for both Democrats and Republicans

Illustration by Ajay MohantyThe guardian of the punch bowl is at risk of becoming the punching bag.The Federal Reserve continued to signal at its meeting Thursday that “further gradual increases” in interest rates are coming for the “strong” US economy. It’s a message that could be increasingly unpopular as Democrats and Republicans seek more spending next year while gearing up for the 2020 fight for control of Congress and the White House.Democrats soon to be in command of the House of Representatives are pushing for infrastructure spending and a wider distribution of gains to workers from a hot job market. Republicans want economic growth to accelerate from their tax cuts, deregulation and defense spending. Steadily rising interest rates can appear contrary to both goals.Caught in the middle is Fed Chairman Jerome Powell, who’s already taking flak from President Donald Trump for boosting borrowing costs while the economy is humming.Powell, perhaps anticipating even more political heat, is being proactive in his outreach to Congress, which has oversight of the central bank: He has met with or called lawmakers 77 times since becoming chairman in February, according to his calendar. During September alone, a busy month that included a policy meeting, his diary shows 18 meetings or telephone conversations with congressional members.“On the House front, there will definitely be more criticism. They will say clearly we have good outcomes, so what’s the hurry?” said Edward Al-Hussainy, a senior analyst for interest rates and currencies with Columbia Threadneedle Investments. “On the Republican side, the question will be, ‘If we roll out more stimulus, are you going to offset it? That doesn’t work for us.”’The reality is, both parties need to preserve the investing public’s trust in the Fed to underwrite their political goals. Without sound monetary policy that keeps inflation in check, neither wage gains nor moderate borrowing costs on growing federal debt are sustainable.Big loadDebt held by the public as a percent of GDP; actual and estimates starting 2018“Austerity is going to be on nobody’s platform for the foreseeable future,” said Lou Crandall, chief economist at Wrightson ICAP. Democrats and Republicans will push the US toward “peak fiscal indiscipline” over the next couple of years, he said.What both parties have learned is that, for now, the debt-carrying capacity of the economy appears to be high. One reason is the US continues to be the world’s biggest provider of safe assets.“We are the prettiest pig in the pig pen and we will be so for some time,” said David Beckworth, a senior research fellow at the Mercatus Center at George Mason University. “We have greater debt capacity than we thought we had.”The premium investors collect for the risk of locking their money up in a 10-year Treasury note, instead of rolling their cash over in short-term maturities, is negative by one measure, meaning investors see little risk of loaning their money to the government for a decade.“Treasury yields are still historically low and debt costs are still pretty attractive,” said Justin Waring, investment strategist for the Americas at UBS Global Wealth Management in an interview. “If you were going to run a record deficit this is the time to do it.”Following the passage of the Republican’s Tax Cut and Jobs Act of 2017 — which rocketed projections for debt held by the public to 96.2 percent of gross domestic product by 2028 from 76.5 percent in 2017 — 10-year Treasury yields are hovering around 3.19 percent compared with 2.4 percent at the end of last year.Over that same period, long-term inflation expectations, derived from Treasury Inflation-Protected Securities, have barely risen to 2.05 percent from 1.98 percent. That’s another sign of investor faith that central bank won’t print money to pay the national debt.The way the Fed keeps inflation expectations nailed down in a hot economy is by signaling it is vigilant and will continue to nudge rates higher so long as growth and hiring is strong.Futures market investors are pricing in a 75 per cent probability that the Fed hikes a fourth time this year in December. U.S. central bankers project three more hikes in 2019.Fed officials don’t know how far they have to raise rates to keep supply and demand in balance or where “normal” is in the post-crisis economy. If financial markets tailspin, or if activity cools suddenly, they will pause and probably face some blame. At least one loud voice of Democratic orthodoxy is telling them to be careful.“The risks of excessive tightening seem substantial,” former US Treasury Secretary Lawrence Summers wrote in the Financial Times Nov. 5, while trying to distance himself from Trump’s Fed bashing. “On almost every occasion in the past 50 years when the Fed has tightened in a sustained way, the result has been recession.”
Source: Business Standard