The election of Donald Trump as the next president of the United States produced a strong reaction in global financial markets. Stocks rallied, but even more interesting was the significant strengthening of the U.S. dollar and a spike in bond yields – both driven by higher inflation expectations.
What the financial markets are telling us is not just what economic policies a Trump administration and a Republican-controlled Congress will pursue, but also how the Federal Reserve will react to these policies.
But what exactly are the markets saying? First, they are relaxed about the election’s outcome. This is a fair indication that investors believe that President Trump will never succeed (or even seriously try) to carry out many of the “promises” on trade and immigration he made during the election campaign.
Second, there is no sign of anxiety about a U.S. recession or a global economic crisis. Stocks have rallied more or less continuously since election day. We are getting the same message from the currency markets, where the dollar has continued to strengthen and is now at its strongest level in 13 years.
The U.S. stock rally gathered steam after Donald Trump’s victory (macpixxel for GIS)
Dollar appreciation began after the U.S. election result was known (macpixxel for GIS)
The bond market, however, is most revealing about policy expectations for the new administration. Yields of 10-year Treasury bonds have jumped nearly half a percentage point since November 8. This tells us that investors see a fairly large-scale fiscal stimulus coming. Put in another way, the Trump administration will likely adopt a basically Keynesian stance, using fiscal policy to boost aggregate demand in the U.S. economy.
We know that Mr. Trump has already pledged to increase Federal spending on infrastructure, and he has also vowed major tax cuts. With Republicans firmly in control of both the House and the Senate, he should be able to deliver on some of these promises.
It might seem paradoxical that a Republican president would be a big spender, but recent history shows that Republicans have, on balance, been somewhat less fiscally conservative as presidents than their Democratic counterparts. Since World War II, U.S. public spending has grown by about a quarter of a percent per year faster under Republican presidents. The bond market dynamics suggest investors believe it will be no different with Donald Trump in the White House.
What will he spend the money on? Mr. Trump’s own victory speech leaves little doubt that it will be on infrastructure. “We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he told his supporters on election night. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.”
While the bond market is pointing to an expansionary fiscal policy agenda from the Trump administration, it is also notable that short-term bond yields did not initially rise as much, resulting in an upward tilt to the yield curve.
This shows that markets did not expect the Federal Reserve to fully offset the impact of a fiscal stimulus – at least while inflation expectation remained below 2 percent. They still anticipated the Fed will increase interest rates, but it was by no means a given that these rate hikes will be aggressive – at least not in the near term.
To some extent, this reflected the Federal Reserve’s own calls for fiscal easing to help support aggregate demand. This shift seems to have started on August 26, with comments by Federal Reserve Chair Janet Yellen at the Kansas City Fed’s Economic Symposium in Jackson Hole, Wyoming. Her remarks are worth quoting at length:
Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy. For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.
Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.
The key passage on “promoting capital investment,” of course, means more government infrastructure spending.
Since August, we have heard this message again and again from Fed officials. In a speech to the New York Economic Club on October 17, Vice Chairman Stanley Fischer said that “[s]ome combination of more encouragement for private investment, improved public infrastructure, better education and more effective regulation is likely to promote faster growth of productivity and living standards.”
Bonds and Trumpflation
One consequence of massive government infrastructure spending would be to push up the so-called equilibrium interest rate. This would allow the Fed to raise interest rates without really tightening monetary conditions, so long as the increases were lower than the rise in the equilibrium rate.
This points to the potential for an alliance between the Trump administration and the Federal Reserve, which could produce simultaneous fiscal and monetary easing in 2017. It is this scenario that the markets have recognized and discounted.
The consequences are very clear in terms of inflation expectations (as measured in the bond market), which have jumped since the election. Investors’ conclusion that Donald Trump’s economic policies will prove inflationary gave rise to the now-popular term “Trumpflation.”
Bond yields have topped the Fed’s inflation target with expectations close behind (macpixxel for GIS)
The rise in inflation expectations shows that the financial markets believe the Fed will allow faster price growth on the back of Mr. Trump’s policies. This is not a total surprise in light of the Fed’s signaling over the past several months. In this regard, it should be noted that both inflation expectations and actual price growth in the U.S. have remained below policymakers’ 2 percent target for a considerable time.
The Fed’s last word
While the Federal Reserve will be happy to see Mr. Trump’s policies push up inflation as long as consumers and producers expect price growth to remain below 2 percent, the situation will change dramatically once expectations significantly exceed that level. Then, it will be natural to expect the Fed to raise borrowing costs more forcefully to curb inflationary pressures.
This is in fact something we are starting to see. As bond yields and inflation expectations have risen, investors began to price in more aggressive rate hikes from the Federal Reserve, and inflation expectations stopped moving upwards. It is clear investors only expected the Fed to tolerate higher inflation only as long as (medium-term) inflation expectations remained below 2 percent. And after the initial election “shock” drove those expectations above 2 percent, they came to an abrupt halt.
Longer-term inflation expectations are still creeping up after a post-election spike (macpixxel for GIS)
The practical effect would be to boost aggregate demand in the short term, triggering rate hikes by the Federal Reserve, which will just cause the dollar to strengthen further. The ensuing increase in real interest rates will put downward pressure on private consumption and investment, while causing export growth to slow. Its result will be to crowd out the demand stimulus of Trump’s fiscal easing.
Donald Trump’s “boom” will only materialize if Janet Yellen allows it to happen. She is unlikely to do so if she and the rest of the Federal Open Market Committee (FOMC) believe it will jeopardize the 2 percent inflation target.
This sets up a longer-term conflict between the Trump administration and the Federal Reserve. In this context, it should be remembered that Ms. Yellen’s term as Fed chair ends in 2018. Will President Trump reappoint her if he believes she has undermined his economic recovery program?
One more side effect of this unfortunate policy mix – fiscal easing and monetary tightening – is a probable ballooning of the U.S. foreign trade deficit. This could drive the Trump administration to further escalate its protectionist rhetoric, thereby increasing the risk of a global trade war.
In this regard, it is notable that the president-elect has recently stepped up his verbal attacks on U.S. manufacturers moving their operations offshore and on China. Among other things, Mr. Trump has threatened to slap steep tariffs on foreign-based American companies exporting back into the U.S. Furthermore, he has angered China’s political leadership by holding a telephone conversation with Tsai Ing-wen, the president of Taiwan. This shows how the new administration’s economic policies and diplomatic approach could increase Sino-American trade tensions, especially if continued dollar appreciation causes the U.S. trade deficit to balloon.
The combination of a stronger dollar, higher U.S. interest rates and increasing protectionism is particularly bad news for emerging markets with large funding needs. Since the election, we have seen stock, bond and currency markets come under pressure in countries with big current account deficits, especially Mexico, South Africa and Turkey.
In conclusion, U.S. economic growth will probably accelerate in the near term on expectations that the new chief executive will preside over a significant fiscal stimulus. But there is a considerable risk that these policies will spark growing friction between the Trump administration and the Federal Reserve, and between the U.S. and its foreign trading partners. That could set up global financial markets for a bumpy ride in 2017.
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