Three Questions for the Chair
The most important event this week will be Janet Yellen’s semi-annual testimony to Congress. A key issue will be how she responds to three questions on fiscal stimulus, namely: can we afford it, do we need it, and how will the Fed respond to it?
Before she is interrogated on these matters, however, she will warm up the crowd by expounding on the current state of the economy. Very likely she will express some satisfaction at the cumulative progress made in the almost eight years of the current economic expansion. And data due out this week should support her perspective.
Initial Jobless Claims, on Thursday, should continue to hover near 43-year lows. Retail Sales on Wednesday, should log solid gains, and, while real consumer spending looks to be tracking below 2% growth for the first quarter, the economy overall appears to be achieving year-over-year growth of between 2.0% and 2.5%, right in line with its expansion average. Inflation indicators should also be to the Fed’s liking, with CPI in January potentially up by 2.5% year-over-year, in its strongest read in almost five years.
Chair Yellen may well linger in her prepared remarks because, for someone who would like to avoid politics, the questions from then on will likely become awkward.
First, she may well be asked whether the Federal Government can afford more fiscal stimulus. (The most pointed questions may reference “tax cuts for the rich”, but exactly the same question could be asked about increased spending on defense, veterans’ affairs or infrastructure.)
I’ve always hated the question “can we afford?” because it’s so ambiguous. In years gone by, when my wife has asked me, “can we afford to remodel the kitchen?” the answer is (a) yes – if you mean “could we”, since the bank would lend us the money and (b) no – if you mean “should we” because prudently, given the uncertainty of life and our need to save for retirement and our kids’ college costs, it would likely leave us in bad shape in the long run.
By criteria (a) the Federal Government can easily finance further fiscal stimulus. However, by criteria (b), further fiscal stimulus seems reckless. The federal budget deficit for the last fiscal year was $587 billion, or 3.2% of GDP. According to a recent report by the Congressional Budget Office, under current law, that deficit would swell to $1.4 trillion by 2027, pushing the national debt in the hands of the public to almost $25 trillion or nearly 89% of GDP from its current 77%. Moreover, even these projections rely on optimistic assumptions that real GDP will climb by close to 2.0% annually over the next decade (compared to 1.3% over the past 10 years), that unemployment will hover at 5% or below and that the yield on 10-year government bonds will stay below 4%.
In short, under current law and a relatively rosy scenario, the federal budget will gradually spiral out of control. It would be reckless to take steps to worsen this trajectory, unless it was to meet some dire national security or economic need.
The proponents of fiscal stimulus may argue either that they will pay for tax cuts with offsetting spending cuts or that, because of “dynamic effects”, the actual budget hit from stimulus would be much less than suggested by static analysis.
On the first issue, there would be little meaningful stimulus if government spending is cut by as much as taxes. Government spending, even if wasteful, counts as aggregate demand just as much as consumer spending does and it is even likely that some tax cuts, such as eliminating the estate tax, would result in a net negative impact on aggregate demand, if coupled with spending cuts to fund it.
On the second issue, it is true that a tax cut that led to a surge in economic activity could fund some of its own expense. This is why many who have advocated tax cuts have insisted on “dynamic scoring” by the CBO and Joint Committee on Taxation in assessing their true cost.
However, these dynamic effects would be greatest in an economy that is far from full employment, since tax cuts could allow the economy to absorb slack more quickly. If today’s economy is actually at full employment, these dynamic effects will be very weak.
So is there any significant slack left in the labor market? While both the Fed Chair and the President have argued that there is, (although to wildly differing extents), the evidence doesn’t really support that perspective. Consider that:
–The unemployment rate, at 4.8%, is lower than it has been 81% of the time over the past 50 years.
–The four-week moving average of initial claims for unemployment benefits is at its lowest level in over 43 years, and,
–Despite the best technology in history to help workers connect with jobs, there are a near-record high 5.5 million unfilled job openings in the U.S. economy.
There is still a slightly elevated number of people who are working part-time for economic reasons and wage growth remains slow. However, the first of these problems likely reflects the evolving structure of part-time employment in the low-end services sector, while the second may reflect a simple misperception, by both workers and employers, about how much slack there is in the labor market. If you are told the job market is horrible, you may not want to ask for a raise.
To be fair, in recent comments, even Chair Yellen seems to be coming round to the idea that the labor market is nearly out of slack. Consequently, while the Fed might well cheer supply-side measures to increase productivity (such as tax and regulatory reform), or boost the labor force, (perhaps through more legal immigration), it is unlikely to endorse broad fiscal stimulus at this time.
Finally, and most importantly for investors, how is the Fed likely to respond to fiscal stimulus if it occurs? Despite the very dovish tendencies of the current Federal Open Market Committee, it will likely “lean against” any fiscal expansion. Consequently, if the Administration does announce a big tax cut proposal in the next few weeks, as the President indicated on Thursday, the odds will rise on a Fed rate hike on March 15th.
This is not necessarily bad news for the equity market. In the past, the stock market has tolerated rate increases from low levels very well and equity investors have much more at stake in the corporate tax debate than in slight modulations in the pace of Fed tightening. However, for the bond market, it is important. Today’s very low interest rates depend on maintaining the very soft landing that the economic expansion has achieved so far. We are simply too far down the runway to start revving the engines now.
Chief Global Strategist