Federal Reserve policy has been at the forefront of our economic forecast for nearly the past decade, reinforcing an environment of historically low rates. While the latter is likely to be a lingering theme for some time going forward as the “recovery” remains on improved, albeit moderate footing, the former is about to change. The Trump administration has vowed to enact a number of unprecedented proposals including massive government investment, reduced regulation, as well as a simplified and lowered tax rate policy among others. The notion of such positive change has sent shock waves through the market, raising expectations for a resurgence in the American economy and moving fiscal policy ahead of monetary policy. With few specifics available, however, accounting for all the potential iterations of such an ambitious agenda is virtually impossible. Of course there is always uncertainty in fiscal policy, particularly with a new administration, and while the sheer number of unknowns appears overwhelming, with cautious baseline assumptions we identify a number of themes that will shape the economic outlook for 2017 and beyond.
Corporate Investment and the Consumer
Fiscal stimulus will be a primary driver of economic activity as we turn the corner into the New Year. A simplified tax and reduced regulatory burden will boost corporate participation in the market, helping to reverse the restrained activity of the past several years. Amid tax uncertainty and ample regulation, business investment has remained sidelined in the aftermath of the Great Recession. For years businesses have been hesitant to put cash to work in structures, equipment and – arguably most important – high-wage, full-time employees. A growing shift towards technology replacements and investment in automation, however, could result in improved productivity gains near-term perpetuating the current moderate conditions in the labor market.
Trump has vowed to repeal Dodd-Frank and reduce sweeping bank reforms; furthermore, the president’s most recent appointment of Tom Price as secretary of the Department of Health and Human Services, the author of the Republican proposal for health care reform, increases the probability of a near-term overhaul of the Affordable Care Act while keeping coverage for people with pre-existing conditions, and allowing Americans under the age of 26 to stay on their parents’ plans. Among regulatory burdens and tax uncertainty, rising health care costs have been one of the top restraints to business development and expansion, as well as employment opportunities. Of course, modification to the ACA will not arrest escalating health care costs resulting from technological advancements or the rising demands of an aging population.
Consumers will also benefit from a lower and simplified tax plan that puts trillions of dollars back in the pockets of working Americans and business owners. Such a plan could arrest further deterioration of the consumers’ purchasing power, as well as the consumers’ appetite for credit accumulation. Additional discretionary income will help alleviate mounting pressure from waning income growth and reflate the household balance sheet. Furthermore, a reduced tax burden will provide additional wealth to offset rising health and housing costs which account for an increasingly large proportion – nearly 50% – of the average household’s monthly expenditures.
Trade and Labor Markets
With heightened attention on “international fairness” and protectionist policies, the Trump administration has vowed to reform immigration policies in the United States. Despite initially painting with a broad brush, the administration’s focus will more likely remain on the deportation of illegal aliens with a criminal background, still impacting over 2 million immigrants. The more narrow focus, however, will limit the disruption to the labor market, particularly in sectors heavily reliant on immigrant labor. The security of the border, furthermore, will no doubt remain a top priority embodied in the notion of a proverbial “wall.”
While instigating pro-growth policies and creating incentives for businesses to grow and remain in the United States, the Trump administration appears equally willing to employ the stick along with the carrot. Renegotiating trade deals that seemingly leave the U.S. disadvantaged may appear a benevolent party initiative in line with the intention to “make America great again.” The imposition, however, of large penalties or a proposed 35% tariff on imported goods will only serve to drive costs higher, offsetting gains from a reduced domestic tax burden and offering moderate support to inflation, while at the same time acting as an anchor to domestic growth potential. Any restrictions to the free flow of capital, labor or goods will result in a net loss of topline activity in the U.S. and a reduction in gross domestic product. Furthermore, threatening cost penalties could spark a trade war with some of the country’s key trading partners and allies, including China, which has already threatened retaliation. Rapidly rising import costs will act as a large net drag on the consumer and the economic recovery.
The dollar has increased to a fourteen-year high since the election relative to a basket of global currencies, complicating the more recent rebound in domestic manufacturing that began late spring. Modest relative to the more robust levels of production in 2014, the more recent improvement remains intensely susceptible to international market conditions. In the longer-run, a strong viable currency is no doubt desirable. However, in the near-term as the U.S. economy struggles to move beyond 2% growth and domestic production fights to grow legs, a rapidly rising dollar makes U.S.-made goods more expensive and less attractive on the global stage.
Inflation and Debt
A massive fiscal initiative would help reflate the U.S. economy after years of lackluster price pressures. Vowing to rebuild roads, bridges, tunnels, schools and airports that are “second to none” in the developed world, such a sizable agenda will come at a hefty cost, making it difficult to push through even a Republican controlled Congress. After all, many legislatures will be thinking about their own political livelihood in the next two to four years. In other words, Congress will be focused on adhering to what voters consistently say are number one and number two on their list of concerns: 1) the economy and jobs – which increases the likelihood of passing reduced tax and regulatory reform to jumpstart the economy, and 2) a declining appetite for a growing government balance sheet.
With debt to GDP currently over 75% and projected to rise over 85% within the next 10 years, under the spending initiatives proposed by Trump, the debt level would likely skyrocket to over 100%. Coupled with a rising rate environment, albeit it minimally, such massive unfunded spending would simply compound the pressure on the tax payer already footing an annual net interest payment north of $300bn dollars. As a result, Congress is likely to demand an equal offset to the incoming administration's spending initiatives. In other words, Congress is likely to force Trump’s stimulus measures to prove balance sheet neutral (paid for by raising taxes or cuts elsewhere.) Thus, while arguably a desirable reallocation of capital and government receipts, against the backdrop of moderate global growth, the positive yet restrained levels of domestic inflation are likely to remain despite the recent pickup in expectations.
Reminiscent of the 2013 taper tantrum, the thought of fiscal stimulus reflating the economy has driven bond yields over 55bps higher since the start of November. However, also mirroring the taper tantrum, rates have yet to stabilize, likely overshooting a sustainable range at this point. In the short-term, the run-up in yields and dollar may well continue into the first quarter of the year or longer, barring some economic shock or significant change in tone from the Trump administration. But what in the economy has dramatically changed since November 1st? Arguably, nothing. At this point the market is simply choosing to cherry pick the policies deserving of focus – ignoring tariffs and isolationism in lieu of reduced taxes and regulatory reform – rather than economic fundamentals. Even pro-growth initiates, however, will be slow to implement and the positive impact on the economy slower still.
Looking beyond President Trump’s first 100 days, the market is likely to more clearly weigh the limitations of optimism alone surrounding a pro-growth administration with a more moderate economic reality, particularly as higher rates begin to squeeze activity in interest-rate sensitive sectors of the economy such as housing and consumer finance. While arresting a further and more rapid erosion of economic conditions under the status quo, the lack of “liftoff” from the anticipated policies of the next four years will replace the most recent upward trajectory in rates with a more tempered trading range. The Trump trade has already begun to lose steam in global markets as the reality of unresolved political and fiscal issues cloud the market’s willingness to jump on or remain attached to the bandwagon of euphoria.
As Richmond Fed President Jeffrey Lacker said early in November, faster fiscal stimulus would warrant a faster pace of rate increases. Of course, the intention of his comment was that more rapid fiscal stimulus is likely to result in quicker economic activity and improved labor and inflation conditions, which would in turn warrant a more accelerated removal of accommodation. In other words, the Fed will continue along a path of higher rates at a pace justified by the underlying momentum in the economy as the Committee remains, first and foremost, data-dependent. Therefore, unlike the anticipatory liftoff in December 2015 or the recent run-up in the market fueled by expectant pro-growth policy, the Fed will increasingly judge the appropriateness of rate hikes on the economic impact of a Trump administration rather than political promises.
At this point, the market fully priced the recent December rate hike, as well as potentially three increases next year. And while the Fed took advantage of the market’s green light to push through the second-round increase since liftoff, the accompanying Summary of Economic Projections (SEP) showed that the Committee’s outlook for growth and inflation, as well as the longer-run terminal level for Fed funds rate remains tempered. Pro-growth policies, including a reduced tax and regulatory burden, will help alleviate the downward pressures plaguing the economy for a number of years; however, offsetting mounting weakness will still result in a restrained, moderate expansion. As a result, following the recent December increase, the Fed is likely to disappoint the market and maintain a one rate hike a year policy agenda again in 2017, driving down rates on the longer end of the curve. In other words, we expect the Fed to reiterate an intention of slower and lower for longer. After all, even some policy makers chomping at the bit to hike rates have suggested only a single rate increase through 2018 as a result of a little or unchanged economic regime over that same time frame. Stronger economic conditions beyond fiscal policy makers’ expectations would of course warrant a second rate increase next year (third overall), likely to occur at the mid-year point.
Furthermore, with a number of anticipated influential appointments, the president will also have the opportunity to fill two vacancies on the Board of Governors that have remained empty since Jeremy Stein left for retirement in April 2014 and Sarah Bloom Raskin left to become Deputy Secretary at the Treasury in March 2014. Seen as a guiding voice, the seven members of the Board can greatly influence the direction of policy. At this point, in the early weeks of 2017, the composition of the Fed will shift dramatically to a more dovish voting Committee. Depending on the president’s nominations, the newcomers could offset the more cautious tilt of the rotating Federal Reserve presidents. A more hawkish leaning Fed would more likely focus on even minimal or relative improvements as justification for a more rapid rate pathway.
-Lindsey Piegza, Chief Economist
 Assuming a simplified tax plan with reduced brackets (12%, 25% and 33%) and a reduced corporate tax rate to 15%.
 Assuming a repeal of Dodd-Frank and further reduction of sweeping bank reforms, as well as undoing the current administration’s policies on energy and climate control.
 According to the Congressional Budget Office (CBO).