Tag: Federal Reserve
Asset Allocation Bi-Weekly – Believe It or Not, Fiscal Policy Is Tightening (March 7, 2022)
by the Asset Allocation Committee | PDF
The U.S. economy and government economic policies have many moving parts, but investors often latch onto just one or two indicators or policy initiatives to gauge where asset prices are heading. These days, their focus has been on consumer price inflation and the Federal Reserve’s plan to hike its benchmark short-term interest rate to combat it. Tighter monetary policy should help cut demand, leading to lower inflation, but it will also have a direct negative impact on asset prices. In this report, we argue investors aren’t paying enough attention to another aspect of economic policy. Investors might not realize it, but federal fiscal policy is also tightening, which will further weigh on economic growth. It will be an additional challenge for asset prices.
Investors are often incensed at the enormous numbers that get bandied about when talking about government spending, but it’s important to keep in mind that the overall economy is also enormous. U.S. gross domestic product (GDP) totaled about $23 trillion in 2021. In the decade leading up to the coronavirus pandemic, total federal receipts averaged 16.3% of GDP, while federal spending averaged 21.6% of GDP. The budget deficit averaged 5.3% of GDP. However, to cushion the blow of the pandemic starting in early 2020, the government passed trillions of dollars of emergency spending, ranging from forgivable loans for affected businesses to enhanced unemployment benefits and cash grants for individuals. As shown in the chart, total federal outlays in the year ended March 2021 were up a massive 65.7% from the prior year, even as federal receipts were essentially flat.
The added spending during the pandemic undoubtedly helped preserve economic activity. It also blew out the budget deficit and, against a backdrop of pandemic supply disruptions, has contributed to today’s high inflation as well. However, the chart above shows that this fiscal stimulus has already gone into reverse. In the year ended December 2021, spending was essentially unchanged from the previous year. Because of the rapid economic recovery, government receipts (mostly income taxes) were up 25.7%. Flat spending against a huge jump in tax income helped cut the budget deficit to “just” $2.577 trillion in 2021, or $771.4 billion narrower than in 2020. The deficit in 2021 was only about 11.4% of GDP, roughly half what it was in 2020.
The $771.4 billion in deficit reduction during 2021 was a drag on the economy, but it wasn’t very noticeable because companies and individuals had so much pent-up demand. In addition, companies and individuals still had a lot of excess cash and savings left over from the stimulus programs earlier in the pandemic. The experience in 2022 could be very different. For one thing, forecasts from authorities such as the White House Office of Management and Budget and the Congressional Budget Office suggest the deficit will fall dramatically again this year. In dollar terms, the deficit is expected to narrow by some $1.3 trillion, mostly because of higher income tax receipts and reduced transfer payments to states, local governments, and individuals. That’s exactly like taking $1.3 trillion out of the economy, just as many firms and individuals start to deplete their savings and face much higher price inflation.
As shown in this chart, the fiscal tightening that began in 2021 has been shaving more than two percentage points off the annualized U.S. growth rate for the last several quarters. Taking another $1.3 trillion in net federal spending out of the economy in 2022 will cut several additional percentage points out of the growth rate, on top of the other headwinds to demand. This fiscal drag will be offset partially by factors such as the Biden administration’s new infrastructure spending and reduced demand for imports. Nevertheless, we still expect it to have a major impact in slowing demand, just as the Fed looks set to impose multiple interest-rate hikes. The chart shows that the Fed’s recent rate-hiking campaigns have all occurred during periods of negative fiscal impacts, but none of those periods had fiscal tightening on the scale we’re about to see. This simultaneous tightening of fiscal and monetary policy may help ease inflation pressures. It also means real economic growth in 2022 may be a little better than the anemic rates seen in the decade before the pandemic. That will likely limit the upside for equities and commodities this year. At the same time, it should also limit the downside for bond prices and keep yields from rising as much as some investors now fear.
Asset Allocation Bi-Weekly – #66 “The Path of Monetary Policy” (Posted 1/10/22)
Asset Allocation Bi-Weekly – The Path of Monetary Policy (January 10, 2022)
by the Asset Allocation Committee | PDF
Our expectation of no policy rate hikes this year is an out-of-consensus call in our 2022 Outlook: The Year of Fat Tails. There are a couple of factors that suggest rate hikes this year. First, financial markets have factored in rate hikes. Fed funds futures suggest a greater than 50% likelihood of a rate hike beginning with the March 2022 meeting and have discounted the same likelihood for four 25 bps rate hikes by December. Second, the Mankiw Rule, a derivation of the Taylor Rule, indicates the FOMC is hopelessly behind the curve in terms of rate hikes.
We have created five variations of the Mankiw rule, which calculates a fair value policy rate from core CPI and various measures of the labor market. The most conservative measure puts the recommended fed funds rate at 4.33%; the most radical is 9.27%.
So, given this strong evidence, what is the argument for steady policy? Part of the reason the Mankiw variations are so high is due to elevated inflation. Base effects alone should lead to lower readings on inflation by mid-year, which should cool the impetus for policy tightening. Although the labor markets show signs of being tight, the labor force remains well below pre-pandemic levels. It may give FOMC members pause, worried that tightening could be premature.
This chart compares the three-month average of the labor force relative to its most recent peak. The drop in the labor force seen during the pandemic was unprecedented in the post-war era. It is uncertain whether the labor market has been permanently impaired by the pandemic. It may never return to pre-pandemic levels. It is also possible that as the pandemic steadily shifts to endemic, workers will return. Thus, tightening could prematurely put this return at risk.
Another characteristic of the FOMC since Greenspan has been the attention paid to financial markets. The concept of the “Greenspan put,” which has been attributed to every Fed chair since Greenspan, suggests a pattern where monetary policy is eased to quell turmoil in financial markets.
One clear measure of financial stress is the VIX, which measures the implied volatility of the S&P 500. In general, the FOMC tends to avoid tightening when the 12-week average of the VIX is above 20. For example, after the Fed raised rates in late 2015, policy remained on hold until the VIX fell decidedly. With the VIX currently holding around 20, we expect the FOMC to delay any moves to raise rates until market volatility eases.
Finally, we suspect financial markets are underappreciating the degree of fiscal tightening that will occur this year.
Fiscal spending during the pandemic was extraordinary. However, as that support winds down, it will act as a drag on economic growth. If the FOMC tightens into this austerity, economic growth could weaken more than expected. The consensus real GDP growth for 2022 is 3.9%. That could be at risk if the Fed tightens into falling fiscal support.
Obviously, we could be wrong on our monetary policy call, and if we are, we will adjust. For now, we think there is a case that the market is overestimating the degree of monetary policy tightening that will occur. If we are correct, it’s likely supportive for equities, short-duration fixed income, commodities, and bearish for the dollar.