Markets Are Trapped as Policy Experiments Collide
(Bloomberg View) -- The wide swings in equity prices recently and the rise in bond yields may just be a prelude of what's to come as 2018 shapes up to be a very challenging and volatile year for investors.
Two radical policy experiments are colliding, as unconventional monetary policy accommodation that led to near-zero official interest rates and record purchases of debt securities is reversed at the same time as a bold and risky fiscal spending plan is being enacted. The net effect should be a major shift in liquidity flows with more money being directed and used in the economy, leaving less liquidity -- in the form of higher interest rates and fewer new flows -- for the financial markets.
Why are lower tax rates a risky fiscal experiment? The U.S. is already operating with a debt burden of more than $20 trillion, which has doubled since 2010 and will continue to rise as relatively large budget deficits -- which the Congressional Budget Office has said may exceed $700 billion in fiscal 2018 -- more than double in the next decade based on current tax and spending policies. With a sea of red ink forecast for as far as the eye can see, the conventional policy response would be to pursue a set of tax and spending policies that would steadily and substantially reduce the scale of budget deficits.
Yet, in December, Congress decided to leverage the government balance sheet even more in order pay for the tax cuts. That decision is risky and unprecedented from a fiscal policy perspective as the tax cut is projected to add $1.4 trillion to the national debt over the next decade. In fact, the credit rating firm Moody’s Investors Service characterized the decision to lower taxes as “credit negative” for the U.S.
History shows that large tax cuts, or those equal to 1 percent or more of nominal gross domestic product, have occurred when the economy was in or just recovering from a recession or when there was substantial slack in the economy. The largest tax cut in the postwar period was enacted by the Reagan administration in 1981, when the economy was in recession and the jobless rate exceeded 10 percent. The Obama administration's tax cut in 2010, estimated to be the second largest, occurred when the economy was barely growing following the deepest recession in the postwar period and when the joblessness rate also exceeded 10 percent.
The Trump administration's tax cut, meanwhile, was enacted with the economy in its ninth year of recovery and growing close to 3 percent, the unemployment rate at a 17-year low of 4.1 percent, and reports of labor shortages. Adding fiscal stimulus to an economy with solid momentum and a tight labor market should lift nominal and real GDP growth rates well above previous estimates, making it difficult for monetary policy makers to maintain their commitment to a measured normalization of official rates and a gradual tapering of the central bank's balance sheet assets.
Investors need to watch not only for changes in monetary policy, but also for a significant break in the signals from the two yield curves: the market yield curve and economic yield curve.
Currently at about 135 basis points, the market yield curve measured by the difference between the federal funds rate and the yield on the benchmark 10-year Treasury note could narrow as policy makers move rates higher in response to faster real and nominal GDP growth. However, the economic yield curve, or the spread between the federal funds rate and the growth in nominal GDP, could steepen from the current level of 300 basis points as lower taxes spur consumption and business investment and causes nominal GDP to accelerate faster than the increase in official interest rates. That curve is already steep, exceeding the average of 100 basis points in the 1990s economic expansion and 200 basis points during the growth cycle in the 2000s.
Investors and even policy makers might interpret the future flattening in the market yield curve as a warning sign of pending slowdown in the economy. That would be a mistake, since maintaining a federal funds rate well below the growth rate in nominal GDP runs the risk of creating even more inflation down the road, forcing a more wrenching change in monetary policy at some point.
It is hard to see how the collision of two policy experiments does not lead to higher official and market interest rates, increased volatility in the financial markets, and downward pressure on financial asset prices.
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.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.
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