FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 27, 2016
1. 3Q Gross Domestic Product Rises More Than Expected
2. Fed Seems to Admit That ZIRP Didn’t Work as Expected
3. President Trump Willing to Increase Domestic Spending
4. Time for the Fed to “Normalize” Monetary Policy
5. “Handing Down Your Legacy” Still Available For Free
The Fed Open Market Committee seems to have admitted, at long last, that its zero interest rate policy (ZIRP) simply hasn’t worked in terms of stimulating the US economy. Now the Committee seems intent on “normalizing” short-term interest rates, with three more rate hikes planned for 2017. We’ll see about that as I will discuss below.
The Fed is also now calling on the government to increase spending in an effort to goose the economy. Ironically, the Fed is essentially saying that monetary policy alone is not enough and that Uncle Sam needs to do more, even if that means increasing the budget deficits. This is very unusual.
Before we get to that discussion, let’s take a look at last week’s better than expected report on 3Q GDP. In its third estimate, the Commerce Department reported that 3Q GDP rose by 3.5% (annual rate), which is the best showing in two years. I’ll have the details below.
Due to the holidays, today’s E-Letter is a little shorter than usual. I hope you and yours are enjoying the holidays and I wish you a happy and profitable New Year!
3Q Gross Domestic Product Rises More Than Expected
The Commerce Department reported last Thursday that 3Q GDP rose by 3.5% which was above the pre-report consensus of 3.3% and better than the previous estimate of 3.2%. The report noted that business investment, consumer spending and government spending all increased more than previously estimated in the 3Q.
While the 3.5% estimate for the 3Q was welcome news, it was also met with some degree of skepticism given that growth was only 1.4% in the 2Q and 0.8% for the 1Q. Assuming the 3.5% estimate holds up, that’s still less than 2% growth for the year, and well below the 2.6% GDP growth in 2015.
Fed Seems to Admit That ZIRP Didn’t Work
As was widely anticipated, Federal Reserve officials voted on December 14 to raise short-term interest rates by a quarter percentage point — only the second increase since the 2008 financial crisis. The Fed’s policy statement suggested three more rate hikes in 2017. This time last year, the Fed suggested four rate hikes in 2016, but we only got one.
This time around, it appears that the Fed has finally come to the realization that its zero interest rate policy (ZIRP) simply has not delivered the goods in terms of stimulating the economy. Despite the surprising upturn in the 3Q, the economy has been considerably weaker in 2015 and 2016 than it was in 2013 and 2014.
In a speech earlier this month, the president of the New York Fed, William Dudley, spoke about “the limitations of monetary policy.” He suggested a greater reliance on “automatic fiscal stabilizers” (ie – more government spending) — such as extending unemployment benefits, cutting the payroll tax, etc. That would “take some pressure off of the Federal Reserve,” he noted. Never mind that those suggestions would balloon the budget deficit.
Speaking two weeks earlier at the Council on Foreign Relations, Fed Vice Chairman Stanley Fischer touted the power of fiscal policy to enhance productivity and speed economic growth. He called for “improved public infrastructure, better education, more encouragement for private investment and more effective regulation.”
President Trump Willing to Increase Domestic Spending
That sounded a lot like President-elect Donald Trump. Indeed, the markets seem to be expecting a bigger, bolder version of Mr. Fischer’s suggestions from the Trump administration. Here’s a look at some of the federal spending Mr. Trump has suggested:
• Infrastructure: Trump campaigned on $1 trillion in new infrastructure spending over 10 years ($100 billion a year), though the details are not fully worked out. The left thinks green-energy projects — such as windmill farms — qualify as infrastructure. I’d prefer more Interstate highways, roads and bridges and repairing those that already exist.
• Education: Nominating Betsy DeVos to lead the Education Department shows Mr. Trump’s commitment to real education reform, including expanded school choice. Much of America’s economic malaise — including income inequality and slow growth — can be laid at the feet of deficient schools. Although some students receive a world-class education, many more get mediocre or worse.
• Private Investment and Deregulation: Mr. Trump promises progress on both fronts. He is filling his cabinet with people — including Andy Puzder for Labor Secretary and Scott Pruitt to lead the Environmental Protection Agency — who understand the burden that Washington places on job creators.
Businesses need greater regulatory certainty, and reasonable statutory time limits should be placed on environmental reviews and permit applications. That, along with tax cuts, should do the trick for boosting investment.
The one big cloud that darkens this optimistic forecast is Mr. Trump’s anti-trade stance. Sparking a trade war could undo all the potential benefits that his policies may bring. David Malpass, a senior Trump adviser, argues that trade deals like the North American Free Trade Agreement are rife with special benefits for big companies, and that they do not work for America’s small businesses. Trump wants to renegotiate these deals to make them work better.
Time for the Fed to “Normalize” Monetary Policy
All that said, central bankers have a role to play as well. The Fed’s ultra-low interest rates were intended to be stimulative, but they also squeezed lending margins, which further dampened banks’ willingness to loan money.
There’s a strong case for a return to normal monetary policy. The prospects for economic growth are brighter than they have been in some time, and that’s good. The inflation rate may tick upward, which is not good. Both factors argue for lifting short-term interest rates to at least equal to the expected rate of inflation. Depending on one’s inflation forecast, that suggests moving toward a Fed Funds rate in the range of 2% to 3% over the next two years.
The Fed need not act abruptly, but it also does not want to get further behind the curve. Next year there will be eight meetings of the Fed Open Market Committee (FOMC). A quarter-point increase at every other meeting, at least, would seem to be in order.
This could produce some blowback from Congress and the White House. Paying higher interest on bank reserves will reduce the surplus that the Fed returns to the Treasury each year — thus increasing the deficit. But the Fed could ease the political pressure if it stopped resisting Republican lawmakers’ efforts to introduce new monetary rules that would curb the central bank’s discretion and make its policies more predictable.
This wouldn’t be an attack on the central bank’s independence, as Fed Chair Janet Yellen has repeatedly argued, but an exercise of Congress’s powers under the Constitution.
It will also be interesting to see who President Trump appoints to the two vacant seats on the Fed’s Board of Governors, which normally has seven members but has only had five since 2013. President Obama has nominated people to fill these vacancies, but they have not been approved by Congress. All of the Fed Governors are