Fed Policy: Seeking Confidence

The FOMC kept policy rates unchanged this week, with the target range for the fed funds rate at 5.25%-to-5.50%. Importantly, the forward guidance was repeated. It said: “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” In the presser, referring to the high-side CPI surprise for February, which followed high-side surprises for January’s CPI and PCE price index, Chair Powell said this “certainly hasn’t improved our confidence”. Indeed, these data likely contributed to the Fed’s easing appetite waning, which was reflected in the ‘dot plot’.

Although the median projection for the fed funds target range midpoint at 2024-end remained at 4.625%, implying 75 bps of easing as before, the mean projection moved up by more than 10 bps. Seven (of 19) participants lifted their forecast by at least 25 bps. There are now nine participants at the median and another nine projecting a higher rate (less easing), so it would take only one participant shifting from the former to the latter to lift the median. Meanwhile, next year’s total easing was reduced to 75 bps from 100 bps with the higher ending level cascading into 2026 (with its 75 bps worth of cuts as before). Interestingly, the longer-run level was also lifted (by a bit above 6 bps) to sit in between 2.50% and 2.625%.

Elsewhere in the Summary of Economic Projections, the median forecast for real GDP growth (Q4/Q4) was raised across the board, to 2.1% this year (+0.7 ppts), 2.0% next year (+0.2 ppts) and 2.0% in 2026 (+0.1 ppts). This run of above-potential (1.8%) growth rates, after 2.5% in 2023, is in stark contrast to the “sustained period of below-trend growth” that the Fed judged was the prerequisite for effective disinflation when the tightening campaign started two years ago this month. Despite the stronger growth, inflation is still projected to hit 2.0% by 2026, but it’s getting there a bit more stubbornly. For this year and next, PCE inflation is 2.4% (same) and 2.2% (+0.1 ppts) with core inflation at 2.6% (+0.2 ppts) and 2.2% (same).

Also in the presser, Powell said the Fed was looking to taper quantitative tightening (QT) “fairly soon”. Since QT started on June 1, 2022, which has since totaled $1.5 trln, reduced activity in the overnight reverse repo (ON RRP) facility has absorbed the impact. Once ON RRPs (currently averaging over $440 bln) fall below the monthly QT pace ($60-to-$95 bln), bank reserves will begin regularly absorbing the impact. Reserves are currently $3.6 trln, above their pre-QT level. Powell said, “right now we would characterize them as abundant, and what we’re aiming for is ample… which is a little bit less than abundant”. But given the uncertainty over where “ample” lives, and wanting to avoid the money market dislocations that occurred in 2019 during the last QT episode, the Fed wants to be extra cautious as reserves begin absorbing QT. Besides, by establishing a noticeably lower QT clip before rate cuts start, a clip that is going to be lasting for longer ‘behind the scenes’, this may help address the confusing policy optics of “loosening along with tightening”.

Bottom Line: Data resiliency and stubbornness are undermining the FOMC’s quest for confidence in inflation’s 2% trajectory. And it’s not only the Fed’s easing appetite that’s waning. We’ve also lowered our call for rate cuts this year from four (25 bp) second-half actions to three (July, September and December), with the net risk it could be lowered further.

Still Dreaming about the Perfect Landing

The Federal Reserve sharply upgraded its forecast for economic growth this year to 2.1% Q4/Q4 from 1.4% projected back in December, joining professional macroeconomic forecasters, including BMO Economics, who have recently upgraded the near-term outlook for U.S. growth. With these revised median projections, the FOMC is largely abandoning the view that it needs to see a prolonged period of below-potential growth to achieve its 2% medium-term inflation objective. We wouldn’t quite go that far. However, this is one outcome, beyond the upward migration of the dots, from this week’s FOMC meeting that deserves to be highlighted, as it is a huge change in the Fed’s thinking around the current monetary policy tightening cycle. In essence, the Fed has just doubled down on its bet for a “perfect landing”: immaculate disinflation from an aggressive monetary policy cycle with almost no material downside on growth and employment. Indeed, the FOMC median is now seeing the unemployment rate in the final quarter of this year at 4%, just a tenth of a percentage point higher than it is today.

While the FOMC doesn’t release its thinking behind these updated growth and unemployment projections, we can guess at the reasons, and Jay Powell dropped some hints during his post-FOMC press conference. The key to achieving a “perfect landing” in 2024 and 2025 is continued strong supply-side improvements and productivity growth. Powell pointed out that improved supply chains and strong labor supply growth last year helped drive solid GDP growth even as inflation came down quickly. Specifically, he cited strong immigration and the improvement in the labor force participation rate for prime age workers (25-54 years olds) as important drivers. One could also add the improvement in labor productivity into the mix. According to the latest data from the Bureau of Labor Statistics, nonfarm business labor productivity jumped to 2.6% y/y in the fourth quarter of 2023 and year-on-year growth rates should remain robust for much of 2024. In short, the recently released GDP forecasts from the FOMC for 2024 and beyond implicitly assume further supply-side gains are achievable without the Fed having to strangle consumer and business demand to tame rampant inflation.

Unfortunately, recent labor market data are less supportive of this narrative of continued rapid improvement in labor supply. For example, labor force growth from a year ago has cratered since November’s 2.2% peak to a meager 0.7% in February. The prime age labor force participation rate hasn’t improved since June 2023 at 83.5%. Meanwhile, the broader civilian labor force participation rate has slipped by three-tenths since last November to 62.5%. At the same time, the Fed’s own Global Supply Chain Pressure Index has sharply reversed direction from significant slack last summer to something more normal today.

The bottom line is we still believe achieving the last mile on the Fed’s inflation mandate will likely take additional squeezing of consumer and business demand as well as a more visible slowing in labor demand. This probably means GDP growth will fall well below 2% for an extended period of time, as we are currently forecasting, with the unemployment rate moving above 4%. If the FOMC median is right on its bullish 2024 GDP growth call, I am concerned we won’t make as much progress on the Fed’s core inflation goals, this year and next, as it would like.

Super Fight II: Biden vs. Trump

This year marks the 50^th anniversary of the rematch between heavyweight boxers Muhammad Ali and Joe Frazier, billed as ‘Super Fight II’. It was the second of three legendary bouts, sandwiched between the ‘Fight of the Century’ and the ‘Thrilla in Manila’. On November 5^th, the nominees for president in the 2024 election, Joe Biden and Donald Trump, will go toe-to-toe again in hopes of winning a second term in office. Current polls compiled by RealClearPolitics give a slight edge to Trump nationally, as well as the lead in all seven battleground states that will ultimately decide the outcome. President Biden released his budget last week, providing a roadmap of his second-term ambitions. For Donald Trump, we have his first-term record as well as public remarks since leaving office. The differences in styles and policies between these two contenders imply vastly different impacts on, and risks for, the economy. This note focuses on the left jabs and right crosses arising from proposals on fiscal policy, trade, regulation and geopolitics.

Fiscal Policy Prospects

When it comes to fiscal policy, the differences between the two candidates and their respective parties are diametric. President Biden and the Democrats have no problem increasing both spending and taxes, relying on the latter more than restraining outlays to control the deficit. And spending priorities won’t be sacrificed for the sake of deficit reduction. By contrast, former President Trump and the Republicans are inclined to cut taxes and constrain spending, with the latter being the main channel for budget control. And tax priorities trump deficit reduction.

Enacting legislation that emphasizes these stark policy differences requires the president’s party to also control Congress, an alignment that tends not to last for long. (The latest polls suggest the Republicans have a slightly better chance of attaining this outcome than the Democrats.) For example, the American Rescue Plan Act and the Inflation Reduction Act were passed during the Biden administration’s first two years when the Democrats controlled the House and Senate. No Republicans voted for these bills, although there was bipartisan support for the other two parts of Biden’s industrial policy trifecta: the Infrastructure Investment and Jobs Act along with the CHIPS and Science Act. During the Trump administration’s first two years when the Republicans controlled both congressional bodies, the Tax Cuts and Jobs Act was passed. No Democrats voted for this bill.

Despite their policy differences, the Trump administration left a legacy of bigger budget deficits owing to tax cuts and pandemic relief, and the Biden administration is leaving one as well, also owing to pandemic relief along with health care outlays and spending on industrial policies. During the past eight years of big deficits (through FY2024), debt held by the public nearly doubled from $14.2 trillion (76% of GDP) to $28.2 trillion (100%). Along with rising interest rates, this has caused net interest outlays to soar, estimated at $870 billion this year and on track to top $1 trillion in FY2026. To put this in perspective: this year, interest payments will top defense spending as an outlay; next year, they will also surpass non-defense discretionary spending. This will crimp fiscal policy flexibility for whomever wins the White House and whichever party controls the House and/or Senate.

On top of rising interest payments, policymakers will face a fiscal cliff in 2026. The tax reductions for individuals, estates, and unincorporated businesses that were part of the 2017 Tax Cuts and Jobs Act (TCJA) are set to expire at the end of 2025. The hit to after-tax incomes in 2026 is estimated at about $290 billion, with more than $200 billion owing to higher personal tax rates. To the extent the latter are reflected in higher withholding taxes to start the year, there could be as much as a 4 ppt headwind for annualized real GDP growth in 2026 Q1.

However, when the authors of the TCJA devised this sunset to pay for permanent corporate tax cuts (because of budget rules), they assumed eventual across-the-board personal tax hikes would be politically unpalatable. They were correct. After taking control last year, House Republicans introduced a bill to make expiring TCJA measures permanent. Presumably, if Trump becomes president and the GOP holds the House and wins the Senate, this legislation could be enacted. The CBO estimates that the total cost through FY2033 of extending expiring TCJA measures would add $3.5 trillion to the cumulative deficit (Chart 1)

President Biden intends to make the expiring tax measures permanent only for those making less than $400,000, paying for the extension via “additional reforms to ensure that wealthy people and big corporations pay their fair share”. These “additional reforms” weren’t detailed in the President’s 2025 budget, but it did propose to increase corporate taxes, such as raising the rate from 21% to 28% and lifting the excise tax on stock buybacks. Biden’s budget also raises taxes on the wealthy by introducing a 25% rate on billionaire’s unrealized income and lifting the top income bracket’s rate from 37% to 39.6% (not waiting until 2026).

The President’s budget is the opening salvo in negotiations for the fiscal year starting October 1. (Congress only this week is likely to pass the budget to fully fund the government for the current fiscal year.) Through FY2034, Biden’s budget has net tax increases of $4.7 trillion, net spending increases of $1.8 trillion, and net interest savings of $0.4 trillion. This results in a $3.3 trillion reduction in the 10-year cumulative deficit (compared to the Office of Management and Budget’s baseline), on the back of higher taxation of corporations and the wealthy. Given offsets from even further taxation, extending the remaining expiring TCJA measures for the under $400k crowd would presumably not add to the 10-year shortfall. However, for this budget proposal to have influence over the negotiations under a second Biden term, the Democrats would have to win back the House and retain the Senate.

The election outcome might also decide the fate of the Inflation Reduction Act, and the suite of tax credits that it provides for electric vehicles (EVs) and other clean energy technologies. The credits have been in the Republicans’ crosshairs since day one. Even if Trump wins but Congress stays divided, there are executive actions he could take to narrow the interpretation of the guidelines and repeal some credits. The Biden administration has taken a broad interpretation (such as in what EVs qualify for the credits), which the GOP argues is helping entities outside the U.S. (and North America). The broadness has combined with latent concerns that the credits could disappear if the GOP scores a triple win, causing a surge in applications and projected cost. The IRA was originally supposed to cost under $400 billion, but recent estimates peg it at well over $800 billion. We suspect even some Democrats lament the consequences of an uncapped tax credit program, no matter how noble.

Trading Places?

President Biden and Donald Trump have one thing in common over trade: they are both wary of other countries gaining an unfair advantage to the detriment of American workers. While Biden added few new tariffs in his first term, neither did he repeal many of Trump’s earlier measures. Moreover, he has restricted China’s ability to purchase advanced AI chips from U.S. companies for national security reasons.

Meantime, Trump is eager to get back in the ring on trade. From the first bell, he is proposing a 10% tariff on all goods entering the country, while also considering a duty of more than 60% on China’s products, including a 100% penalty on vehicles from Mexico if made by Chinese companies that set up shop there. Congress would be virtually powerless to block these jabs, as the president has almost full discretion to impose tariffs on a country deemed to have an unfair trade advantage over U.S. firms. Because of Trump’s initial trade war, the U.S. already imposes a 25% tariff on more than half of imports from China and a smaller 7.5% duty on many other goods. New tariffs would lift U.S. inflation, though a higher dollar (stemming from reduced U.S. demand for foreign products and currencies) could temper the effect. But the real economic harm would come from the inevitable retaliatory actions of trading partners, including allies, that could lead to a series of escalating duties and restrictions. The tit-for-tat moves would impede trade flows, disrupt supply chains, and boost business costs, resulting in higher inflation and weaker global growth.

A Trump presidency could also pose a threat to the free trade agreement between the U.S., Mexico and Canada. Saber-rattling over the USMCA would harm business investment, especially for the two smaller nations, and impede North American economic growth. Both Canada and Mexico have seen their goods trade surplus with the U.S. widen since the deal took effect in July 2020. After China, Mexico runs the largest surplus with the U.S., one that is more than two times larger than Canada’s (Chart 2). Each country could pull out of the USMCA after giving six months’ notice, though it is unclear whether congressional approval is required. The agreement also comes up for review in 2026, when each member must decide whether to renew it beyond the pre-set termination date of 2036.

Regulation and Geopolitics

A Trump White House would have a much lighter regulatory touch than the Biden administration. This might support near-term growth, though possibly at the expense of longer-term risks. Biden favors greater financial industry regulation and supports Basel III proposals that would compel large banks to hold more capital against potential losses. He also favors enforcement of competition policies for businesses, which could raise the bar on mergers and acquisitions. A strong supporter of clean energy initiatives, he recently announced a pause on LNG exports. By contrast, in his first term President Trump rolled back some financial industry regulations put in place after the financial crisis. Along with banks, the energy industry would likely benefit from a Trump win. He may even resurrect the Keystone XL pipeline, which would be a plus for Canada’s energy industry.

Geopolitical tensions could rise if either winner takes a more confrontational approach with China on trade or Taiwan. Trump has threatened to pull the U.S. out of NATO, which could embolden Russia to take more aggressive military action in Eastern Europe.

Final Round

Under a Biden victory, continued deficit spending would support near-term growth with a partial offset from tougher regulations. Under a Trump White House, a likely wider budget gap and lighter regulatory touch could provide an extra boost to growth, with some offset from increased protectionism. Regardless of which fighter’s arm is raised on November 5, the risks for inflation and interest rates could tilt higher amid expansionary fiscal policies. That said, the other major bout on the card that night will determine control of Congress, and a still-divided legislative branch would temper budget shortfalls, while having less influence on trade and regulations.

For the Fed, Trump’s pro-growth policies could make the FOMC a little less willing to ease policy. Chair Powell’s job could also be on the line, fanning uncertainty. Trump appointed Powell in 2018 but says he won’t reappoint him upon expiration of his term as chair in 2026. While in office, Trump even threatened to fire Powell, though a president would need reasonable cause to do so—and not slashing rates isn’t exactly a crime. Going that route could set the stage for the “Thrilla in Capitol Hilla”.