The Economy and Markets Are Starting to Look Like 1994
(Bloomberg View) -- In testimony before Congress in February, Federal Reserve Chairman Jerome Powell said that some of the "headwinds" faced by the U.S. economy in recent years have turned into "tailwinds." I think he understated the issue: The boom in federal spending is more like a tailwind to a hurricane.
History offers few lessons on how to adjust monetary policy when there is an observed shift in factors that have retarded growth. The most recent, closest example is 1994, which turned out to be a terrible year for bonds, equities and the dollar. Back then, the headwinds of defense cutbacks, tax increases, balance-sheet strains and corporate restructurings began to wear off. However, there weren't any noticeable tailwinds.
Nonetheless, the strong rebound in economic growth that materialized over the course of 1994 along with the threat of faster inflation with real interest rates around zero was enough to scare policy makers into a series of tightening moves that pushed the federal funds rate up from 3 percent to 6 percent over the course of 15 months. That was a much bigger increase than anyone anticipated.
Today, there is a growing consensus that the economy will get a big boost from recent tax cuts and increases in government spending. Powell's testimony, where he also said that "fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory," signals a major change in the focus of monetary policy. Consequently, the Fed may be compelled to shift away from an accommodative stance to achieve its policy objectives. Instead, it may move toward a neutral or even a restrictive stance at some point.
Determining how important the shift from headwinds to tailwinds is to the economic and policy outlook is no easy task. Yet changes in government spending offer transparency not often visible in other segments of the economy. For example, President Donald Trump signed a $1.3 trillion appropriation bill last week for fiscal year 2018. This provides the first installment of a two-year, $300 billion increase in defense and non-defense discretionary spending that was part of the budget resolution passed by Congress in February. Most of the money appropriated will feed directly into the government account of gross domestic product, and the rest indirectly into other parts.
Perspective on the potential scale of the federal spending increase can be seen in a recent article on the president's budget published in the March Survey of Current Business by the Bureau of Economic Analysis. It indicated that federal spending in the GDP accounts in calendar-year 2018 would increase by $100 billion to $1.364 trillion, and by $40 billion in calendar 2019. The actual spending gains will be much larger because BEA's analysis is based on Trump's budget proposal. Congress, however, increased the administration's defense request by more than $50 billion and the non-military spending part by more than $100 billion for the two-year period.
All told, the projected increases in federal defense and non-defense spending for 2018 and 2019 will prove to be extremely large, averaging in nominal terms at least 6 percent to 8 percent per year, which would represent the largest increases since the early 1980s. And that would come on the heels of a six-year period in which nominal federal spending increased on average a mere 1 percent.
At some point, Fed policy makers will be forced to abandon their gradualism approach to policy and lift official rates faster and to higher levels than are seen in the "dot plot," pushing real rates close to the 2 percent area in the process. The focus of the financial markets at this moment is on the tariff announcements and the potential threat that a global trade war would have on the growth cycle. Yet the bigger threat to asset valuations will come from the tailwind pressures on official and market interest rates.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Joseph G. Carson is the former global director of economic research at AllianceBernstein.
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