By Shilen Shah, Bond Strategist at Investec Wealth & Investment
Despite the large degree of uncertainty over the path of US fiscal policy, the Fed continues to project a path of stability with the market currently only projecting a gradual interest rate cycle. The uncertainty over fiscal policy however does mean that the Fed is flying blind over the amount of fiscal stimulus the Federal government is likely to provide to the economy over the next 12-18 months. There is an additional level of uncertainty because the new administration could implement a border adjustment tax that will at least in the near term cause import prices to increase (if the USD doesn’t appreciate by an equivalent amount).
As the US economic cycle has progressed, the market’s and policy makers’ focus has moved away from the headline non-farm payroll data to earnings data. Given changes in US demographics, the monthly growth in the non-farm payroll employment is now unlikely to be above 250K on a consistent basis as spare capacity in the labour market has been reduced. The focus has therefore moved towards hourly earnings growth, which whilst somewhat disappointing in January (2.5% vs. a forecast of 2.7%) is still forecast to strengthen over the course of the year. The tightness of the US labour market can for example be seen in initial jobless claim data with the four week average figure now hitting a multi-decade low.
The other important point to note is the composition of the Fed governors. Unlike other Fed members, governors are non-rotating and therefore have an impact on US monetary policy over a significant period. Following Friday’s announcement that governor Tarullo is leaving office early in April, President Trump now has to appoint three new governors with two existing places not currently filled. Additionally, given that Yellen and vice-chair Fischer’s terms are schedule to expire in 2018, the composition of the Fed could change significantly over the next 18-months. President Trump explicitly criticised the Fed during the election suggesting that Yellen’s and Fischer’s terms are unlikely to be renewed in 2018.
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The new administration’s focus on trade policy and specifically the strength of the USD does complicate the picture. Given that the US economic policy is currently operating near full capacity, a large fiscal stimulus will from a policy perspective, be potentially inflationary. Monetary policy in these circumstances should be tightened, potentially counteracting fiscal policy. From a FX perspective, higher US interest rates are likely to be supportive to the USD and could therefore harm a key policy aim of the new administration to support US exports.
The inherent contradictions between trying to maintain a competitive USD, easing fiscal policy (when the economy is close to full capacity) and higher interest rates will have to be resolved over the coming quarters. The policy stance of the Fed appointments will however provide a guide as to how it will be resolved with one of the appointments likely to become the next Fed chair.