PMC Weekly Review - December 15, 2017
A Macro View: Can Congress Fight The Fed?
The joint US House-Senate Conference Committee has agreed to the Tax Cuts and Jobs Act, a framework to overhaul the US tax code significantly, after the bill was passed in different forms in each Chamber. Among a number of changes to the tax code affecting individuals, the joint tax bill reduces the top individual tax rate to 37% from its current 39.6% and temporarily doubles the standard deduction. Corporate taxes are cut as well, reducing the top rate from 35% to 21%, as well as cutting rates on so-called pass-through entities, such as S-corps and partnerships, to about 30%1. Most estimates predict the tax bill will add at least $1 trillion to the deficit over the next decade.
In economic terms, the tax bill amounts to a sizable fiscal stimulus whereby a government either increases spending or decreases taxes to spur economic activity. It is noteworthy that we are in the midst of the third-longest economic expansion in US history. In addition, the unemployment rate is now 4.1%, a 17-year low. Granted, the current expansion has been marked by sluggish gross domestic product (GDP) growth, averaging an annual increase of merely 2.1%. Wage growth also has been relatively muted, and core inflation remains below the Federal Reserve’s (Fed) 2% target. Considering the overall health of the US economy, it is reasonable to ask if the timing is right for fiscal stimulus.
The same sentiment was broached in a recent interview by influential New York Federal Reserve President, William Dudley. His assessment centered on the fact that the US unemployment rate is near the rate at which the Fed believes inflation would accelerate. Mr. Dudley was referring to the Non-Accelerating Inflation Rate of Unemployment (NAIRU), which is the specific level of unemployment that is not expected to increase the rate of inflation. The NAIRU derives from the theory that every economy has a natural rate of unemployment at which the inflation rate will neither increase nor decrease. Although this specific unemployment level is the matter of some debate, the Fed estimates it to be around 4.6%2, well above our present 4.1%.
Assuming the tax bill succeeds in spurring economic growth and expanding payrolls, what are its implications for the Fed’s rate normalization program now underway? This week, the Fed raised its benchmark rate for the third time this year, to 1.25%–1.50%, in response to an improving economic backdrop. In addition, the Fed provided guidance for three 0.25% rate increases for 2018. The Fed also implied it is prepared to raise rates at a faster pace should unemployment drop further and/or inflation tick up beyond these projected targets, potentially muting some or all of the tax bill’s intended effects of spurring the economy. The Fed has incorporated the tax bill into its projections and left the economy’s long term growth rate unchanged at 1.8%, indicating it does not believe the tax reductions will materially affect GDP growth over the long run. In her press conference announcing the rate hike, Fed Chair Janet Yellen indicated she disagrees with President Trump as to whether the tax cuts will pay for themselves, iterating further that the US’s significant government debt problem relative to GDP will be exacerbated by the tax bill.
As of today, it appears likely that the tax bill will land on the President’s desk before Christmas and be signed into law before the New Year, with the hope of stimulating economic growth in 2018 and beyond. Should the tax bill create a significant economic expansion that spurs inflation, we can reasonably assume the Fed will impose even greater monetary tightening than currently planned, thereby muting the intended effect of the tax bill. Given its unclear outcome, it is rational to question whether the tax bill is worth the cost, given our already problematic deficit issues.
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