Last night, Secretary of the Treasury Steve Mnuchin had some rather interesting things to say about inflation: “There are a lot of ways to have the economy grow. You can have wage inflation and not necessarily have inflation concerns in general.” This might be true in periods where we have had tremendous leaps forward in productivity. Absent of that, however, this thinking runs counter to traditional economic thought, which is the thought that governs the Fed. While eyebrows were raised and Jeff Gundlach tweeted, “Mnuchin: policies will raise wages without inflation. Yeah, sure,” the bond market seemed not to take much notice. I found this lack of notice a bit curious, since a statement like that from a Treasury secretary, in a time where market participants are taking notice of rising wages and other inflation measures, would normally cause some indigestion on the long end of the yield curve. Maybe the sharp rise in yields we have experienced the last couple of weeks is viewed as enough of a reaction. Maybe it was Friday and people were just tired of selling. Or maybe the market views that the Federal Reserve will aggressively counter a fiscal policy that it sees as too inflationary. I believe in the latter and think a battle is about to be joined between the White House and the Fed.
There are things pretty unique about President Donald Trump. Many people like his unique qualities and many do not. However, one thing that will not be unique to President Trump is that if the Fed engages in a policy to dampen economic growth to guard against corrosive inflation, he will howl like any president would, especially a first-term president with mid-term elections coming up. If we think about the last three Fed Chairmen prior to Jay Powell—Janet Yellen, Ben Bernanke, and Alan Greenspan—they spanned the presidencies of Ronald Reagan, George H.W. Bush, Bill Clinton, George W. Bush, Barack Obama, and now Donald Trump. For the most part, all of these Fed Chairmen operated in an environment of very low inflation as well as economic and financial market credit crises (1987 stock market crash, savings and loan crisis, Asian Contagion-long-term capital crisis, the dot-com crash, September 11th, and the 2008 near-end-of-the world crisis), where they used monetary policy to counteract financial turmoil and recession. Most of the Fed Fund hikes that occurred during this period of over 30 years were done incrementally from 2004 to 2006, 25 basis point increases for 17 meetings in a row. It should be noted that this march from 1% to 5.25% was the most benign removal of monetary stimulus to date. In hindsight, many blame this slow walk by the Greenspan and then Bernanke Feds as one of the reasons we had the credit explosion of 2007-2008. Other than those incremental hikes, all the Fed Chairpersons have been each of these presidents’ best friend, because over this time period, they have been very accommodating with regard to stimulating economic growth with monetary policy.
In fact, the last Fed Chairman that ran monetary policy counter to his president’s wishes was Paul Volcker. President Reagan chose not to reappoint Mr. Volcker in 1987 and instead appointed a political ally, Alan Greenspan. The chairmen before Mr. Volcker that served presidents Johnson, Nixon, Ford, and Carter were generally if not completely accommodating to the wishes of the White House. Therefore, in the last 54 years, save the eight Mr. Volcker was Fed Chairman, the Fed has been “White House friendly.”
I believe 2018 will be the year this era of love will change. What is important to note is in the last decade, the Fed has become a far more powerful institution with regard to economic policy than it was prior to the events of 2008. As the legislative and executive branches of our government essentially ceded control over influencing the domestic economy to the Fed, the Fed has taken on more power and has become far more visible than ever before. Whether he knew it or not, I believe Secretary Mnuchin fired the first real shot last night. If he believes that the administration’s simulative fiscal policy will increase wages without pushing inflation past where the Fed feels comfortable, he will probably be very uncomfortable with the Fed’s monetary response. The White House and the Fed will be at odds for the first time in a very long time. I believe the Fed response is going to be four FOMC 25–basis-point Fed Fund rate hikes in 2018, bringing the Fed Funds effective rate range to 2.25 - 2.50%.
Additionally, a one-year Treasury bill now yields 2%. With deficit fiscal spending picking up at a fast pace, the supply of bills and notes at the front end of the yield curve will be substantial. This past week we saw over $151 billion short-term bills in one day, a historic amount of daily issuance, and it won’t be a one-time event. Meanwhile, the two-year Treasury note currently yields about 2.23%. That rate barely jibes with three FOMC tightenings in 2018. The combination of supply and a more aggressive Fed will drive yields on the front end up substantially. While I believe yields on the longer end of the yield curve have some more room to rise (3% on ten-year note), the front end of the yield curve can rise more. We are at an abnormal point in history, where we are getting massive fiscal stimulus and deficit spending as the economy is growing substantially; usually you have the opposite. The Fed is concerned with an overheated economy and a forecasted sharp rise in the nation’s debt to GDP. They really can’t do anything more than lecture about deficit spending. However, they can do quite a lot with regard to putting out inflationary pressures. If President Trump is frustrated with the rules of the Senate, I can only imagine how frustrated he is going to get with an independent Federal Reserve running counter to his wishes. Stay tuned!
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