Timothy Fox - Head of Research & Chief Economist
Published Date: 10 April 2017
Last week’s minutes from the US Federal Reserve’s March meeting were notable because the upside risks to the US economic outlook now appear to outnumber the downside risks and because the Fed started to discuss how it will go about reducing its US$4.5 trillion balance sheet – a sign of growing confidence about the future.
Such a message, however, may begin to look incongruous in the context of political developments that are potentially quite destabilising to growth down the road as well as more obviously to financial markets.
The minutes still mention downside risks, but the balance was more tilted to the upside ones related to the possibilities that investment and spending could be stronger than expected, and the possibility of the White House enacting substantial fiscal stimulus. Even though the Fed’s economic projections did not change much at the meeting, it accentuated the positives and continued with three rate hikes in total this year.
So much so that the minutes also included a long discussion on when and how the Fed might begin to shrink its balance sheet, initially by changing its policy of reinvesting the principal from maturing securities in its portfolio, something which is likely to begin "later this year", and earlier than the markets were anticipating.
However, this spring-like burst of optimism appears to be at odds with the deteriorating political environment in Washington. Following the failure to repeal, or even reform, Obamacare doubts are being cast on the ability of Congress to reform taxes, with the House speaker, Paul Ryan, recently appearing downbeat on the prospects of pushing tax reform through quickly. Delays here could quickly pull the rug from under one source of Fed optimism. Other flagship policies of the Trump campaign may also be at risk, including significant infrastructure spending following a congressional budget office report recently highlighting longer-term government debt problems.
In addition, reliance on border taxes designed to generate $1tn in revenue is also looking questionable as it is not clear that the US president Donald Trump can get enough support from his own party to introduce them. As it stands, the only budget for the current fiscal year that has been announced is likely to be broadly neutral in terms of its effect on the economy as it featured an increase in $54 billion in defence spending that was offset by reductions in non-defence spending.
Added to this mix are the congressional investigations into collusion between Mr Trump’s campaign team and Russia, which at the minimum threaten to bog the administration down in defensive mode for the foreseeable future.
Geopolitical issues are also now intruding increasingly into Mr Trump’s in tray, most obviously with the latest US missile barrage on Syria triggering Mr Trump’s biggest foreign policy crisis since the January 20 inauguration. This will have far-reaching consequences, not only with regard to the Syria war, which Mr Trump pledged not to get entangled in, but in terms of the US’s future ties with Russia and China. North Korea was already high on the agenda for discussion between Mr Trump and president Xi Jinping of China at their Florida meeting last week, but the latest developments in the Middle East will also have given urgency to a whole range of other issues. Mr Trump’s capacity to handle numerous domestic policy challenges was already being questioned, something that will get stretched even further with multiple foreign policy issues now on his table.
Against this backdrop, the Fed’s latest "upside risks" bias is beginning to look a little premature. Mr Trump’s domestic stimulus agenda was already looking questionable before the latest events and the last thing that was needed is for his attention to be diverted to other issues. Trade policy and Mr Trump’s protectionist rhetoric have also fallen off the radar of investors, but they are quite easily capable of re-emerging as global tensions rise.
Major equity markets, after a solid first quarter, are posting a mixed start to the new quarter and bond yields appear heavy. The Japanese yen, a barometer of risk, has also been getting stronger. While the Fed’s focus on upside risks appeared to be the notable outcome from the latest FOMC minutes, in the end it may turn out to be the more overlooked warnings about high valuations in the US equity markets that turn out to be the more prescient takeaway.
Probability of March rate hike rises
Fed still uncertain about fiscal policy
Risk sentiment still driving FX