Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

The view from D.C.

June 26, 2017

Heading into the second half of the year, there are a number of key policy uncertainties in Washington. For the Fed, a clear near-term picture is a contrast to the longer-term outlook where views of the market and the Fed have diverged. On Capitol Hill, the repeal and replacement of the Affordable Care Act is still seen as a key hurdle to tackling tax reform and there’s haste to get the ACA repeal done before the July 4 recess. In the months ahead, Congress will have to address the debt ceiling and complete a budget. Lawmakers view Trump tweets and potential charges of obstruction of justice as possible impediments to advancing the agenda.

At the June policy meeting, the Fed laid out its plan to begin unwinding the balance sheet. No start date was specified, but there’s a strong consensus among economists that it will begin in October (to be announced at mid-September policy meeting). The Fed announced starting caps ($6 billion for Treasuries, $4 billion for mortgage-backed securities) for how much will be allowed to run off each month. The Fed will then increase those caps every three months until it reaches $50 billion per month ($30 billion in Treasuries, $20 billion in MBS). Starting slow, the markets shouldn’t have much difficulty, but once the drawdown hits its stride ($600 billion per year), there may be some trouble in absorbing that. The bond market hasn’t reacted much to the Fed’s balance sheet plans. Some of it was likely already baked in, but the markets also seems to doubt that the balance sheet drawdown will proceed as planned.

Economists generally expect the Fed to refrain from raising rates at the September policy meeting to give the balance sheet drawdown an unobstructed runway. However, most expect a resumption of rate increases at the mid-December policy meeting. Beyond that, the outlook is more clouded, partly because we will see a number of personnel changes at the Fed.

Judging from the federal funds futures market, the odds of another 25-basis-point rate increase by yearend are somewhat below 50%. There has been some criticism of the Fed’s June rate hike, which came amid a string of softer economic growth figures and low inflation readings. Here’s the Fed’s thinking. At 4.3%, the unemployment rate is below the long-term equilibrium rate (which the Fed pegs at 4.6%, down from 4.8% seen a just a couple of quarters ago). The Fed firmly believes in the Phillips curve, which describes a relationship between the unemployment rate and accelerating inflation. However, while the principles behind that relationship are basic (it’s supply and demand), the slope of the curve may be flat with some nonlinearity further away from the equilibrium unemployment rate (meaning that at some point, a declining unemployment rate will lead to a much faster pickup in inflation). Inflation is still below the Fed’s 2% goal, but suppose it stays low. The Fed could refrain from raising rates, pushing the unemployment rate lower to boost inflation, but then would have to raise rates later to get back to the equilibrium unemployment rate – a path that would be hazardous (risking a recession). There may be some uncertainty about the equilibrium unemployment rate, but given the balance of policy risks, a gradual path of rate increases is appropriate. If wrong, then the Fed hasn’t raised rates much.

Meanwhile, the Senate healthcare bill is a lot like the House version. Taking the budget reconciliation route, the Republicans in the Senate (who hold a 52-48 majority) need only 50 votes to pass healthcare reform (Vice President Pence would break a tie). Publically, the Republican plan may be a tough sell. It’s a clear trade-off between tax cuts for upper-income households and reduced benefits for millions of the poor and some fear a possible backlash in the 2018 midterms. However, voters have a short memory and Democratic voters tend not to show up for midterm elections. Four Republican senators currently oppose the bill because it doesn’t go far enough in repealing the ACA. There is a lot of pressure to get a completed bill on the president’s desk before the July 4 recess.

There are a number of tax issues in the ACA and a failure to repeal makes broad tax reform virtually impossible. Still, even if Congress passes a bill and the president signs it, broad tax reform was always going to be difficult. There is not enough discretionary spending to cut to balance the budget and no one wants to give up their current tax deductions. Congress has dropped the border tax adjustment as a means of generating revenues to offset the impact of lower tax rates. We may still see a reduction of tax rates into 2018, but on a much smaller scale than was hoped for previously. A drop in the tax rate on retained foreign earnings is seen as a one-off holiday generating some increase in revenue, but only for the short term (that is, not a sustained higher revenue source for the government).

By the autumn, the debt ceiling will have to be raised. It would be better if it were eliminated. In early May, the president signed an omnibus appropriations bill, funding the government through September. In the months ahead, Congress will work on appropriation bills for FY18. We’re likely to see a Continuing Resolution to fund the government into October, but there’s some potential for fireworks related to both the debt ceiling and the budget.

Financial regulation legislation is also on the table, with notable differences between the two chambers of Congress. Federal Reserve “reform” has been an issue for a number of Republicans in recent years, but it’s unclear what we’ll see. Note that, with the president’s approval, Congress has the power to abolish the Fed at any time. Sleep well.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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