Markets have responded strongly to Donald Trump’s election victory, pushing up equities, longer-term interest rates, and the dollar. While many factors influence asset prices, expectations of a much more expansionary fiscal policy under the new administration—higher spending, lower taxes, and larger deficits—appear to be an important driver of the recent market moves.

The Federal Reserve’s reaction to prospective fiscal policy changes has been much more cautious than that of the markets, however. Janet Yellen in December described the central bank as operating under a “cloud of uncertainty,” and the forecasts of Fed policymakers released after the December FOMC meeting showed little change in either their economic outlooks or their interest-rate projections for the next few years. How does the Fed take fiscal policy into account in its planning? What explains the large difference between the reactions of the Fed and the markets to the change in fiscal prospects since the election? I’ll discuss these questions in this post, concluding that the Fed’s cautious response to the possible fiscal shift makes sense, given what we know so far.

Incorporating possible fiscal policy changes into the economic forecast

As a general matter, Fed policymakers view economic or policy developments through the prism of their economic forecast. Developments that push the forecasted path of the economy away from the Fed’s employment and inflation objectives require a compensating policy response; other changes do not. Consequently, to assess the appropriate monetary response to a new fiscal program, Fed policymakers first have to evaluate the likely effects of that program on the economy over the next couple of years.

Fiscal policy influences the economy through many channels. The econometric models used at the Fed for constructing forecasts tend to summarize fiscal effects in terms of changes in aggregate demand or aggregate supply. For example, a rise in spending on public infrastructure, or a tax cut that prompts consumers to spend more, increases demand. Fiscal policies also affect aggregate supply, for example, through the incentives provided by the tax code. To project the impact of a proposed fiscal package on the economy, Fed modelers and policymakers must assess the size and timing of these demand and supply effects, which they do based both on theory and historical experience.

The effects of a fiscal program also depend on the state of the economy when the program is put in place. When I was Fed chair, I argued on a number of occasions against fiscal austerity (tax increases, spending cuts). The economy at the time was suffering from high unemployment, and with monetary policy operating close to its limits, I pushed (unsuccessfully) for fiscal policies to increase aggregate demand and job creation. Today, with the economy approaching full employment, the need for demand-side stimulus, while perhaps not entirely gone, is surely much less than it was three or four years ago. There is still a case for fiscal policy action today, but to increase output without unduly increasing inflation the focus should be on improving productivity and aggregate supply—for example, through improved public infrastructure that makes our economy more efficient or tax reforms that promote private capital investment.

The Fed’s reaction to the prospective fiscal program

While it’s hard to know how much of the market’s optimism reflects expected policy changes under the new administration, the rise in equities, interest rates, and the dollar since the election is precisely the configuration that standard macroeconomics would predict in anticipation of a Trump-backed fiscal expansion. (A similar pattern occurred in the early Reagan years, which was dominated by tax cuts, increased military spending, higher deficits, and rate increases by the Federal Reserve.) According to the minutes of the December 13-14 Fed meeting, monetary policymakers were quite aware of the market’s expectations for fiscal policy, and the staff included in its forecast a “provisional assumption” of a more expansionary fiscal stance. And yet, in the Summary of Economic Projections, meeting participants made few changes to their economic outlook. Notably, at the median, expected real growth was raised by only 0.1 percent for 2017, relative to the September projection, and no change was made for expected growth in 2018. No change at all was made to the median inflation projections for 2017 or 2018. The median path for the Fed’s policy interest rate included just one additional rate increase over the next two years—a small adjustment, probably reflecting changes by only a few participants.

Why was the Fed’s reaction to the prospective fiscal changes so limited, in contrast to the ebullience of the markets? The minutes, as well as subsequent comments by Fed speakers, suggest several reasons:

1. In the face of substantial uncertainty, Fed policymakers often opt for a cautious approach.

As a general matter, Fed policymakers prefer not to whipsaw markets if at all possible. Consequently, and reasonably enough, FOMC participants want to have a strong rationale before signaling a change in their strategy, even tentatively. At this point, the outlook for fiscal policy is much too hazy to prompt such a shift.

Indeed, the format of the Summary of Economic Projections encourages a cautious approach. As I discussed here, FOMC projections are for modal or “most likely” scenarios. Perhaps FOMC participants saw a big fiscal program as a possible outcome but not the most likely scenario.[1] Consistent with that, in December, meeting participants saw increased “upside risks” to their projections. Since asset prices generally reflect an average of possible outcomes rather than just the most likely possibility, the focus of Fed projections on modal outcomes can help explain at least some part of the discrepancy between the apparent caution of monetary policymakers and the surge in asset prices.

2. Based on what is known now, it’s not clear that the near-term macroeconomic effects of fiscal changes will be large, even if major legislation passes.

For assessing the effects of a fiscal program on near-term growth, the details—few of which are currently available—matter a lot. According to the minutes, FOMC participants in the December meeting expressed considerable uncertainty about the “timing, size, and composition” of a prospective fiscal package. But I suspect that in thinking through possible fiscal scenarios, Fed policymakers saw many as suggesting a fiscal program with less near-term economic impact than markets appear to be assuming.

Regarding the size and composition of the program: One key source of uncertainty is political. Passage of new fiscal measures will be made more likely by the facts that Republicans control both the House and the Senate, and that under some circumstances budget bills can pass the Senate with only a simple majority. Still, there are questions. For example, many congressional Republicans have been vocal deficit hawks; will they accept a big fiscal package, if it results in a substantial increase in the federal budget deficit? In particular, will Republicans be willing to support big increases in spending, including infrastructure spending? Alternatively, if Congress opts to reduce the deficit impact of an infrastructure program by financing it through tax credits and public-private partnerships, as candidate Trump proposed, the program might turn out to be relatively small.

Significant tax cuts do seem likely this year, but again the details matter. Structural reforms of the corporate tax codes are being considered, but the range of possible outcomes is wide. Based on what we’ve heard both from Trump and from congressional Republicans, personal tax cuts, especially for higher-income households, are likely to be a big part of the program, and probably the easiest part on which to reach agreement. However, whatever the longer-term benefits of tax reform, high-income consumers may save much of any tax cut they receive, implying that the effects on demand of such cuts are likely to be smaller than the effects of direct government spending.

Regarding timing: No one knows at this point how long Congress will take to pass legislation—fiscal changes can be both complex and contentious. And, once passed, fiscal programs can take a while to have their effect (infrastructure programs, for example, can take a number of years to build out). Consequently, the impact of new fiscal measures may be felt in 2018 or 2019, rather than this year. Of course, that gives the Fed more time to assess the program and determine an appropriate response.

3. Other policy changes will also have economic effects, which may reinforce or offset the fiscal effects.

The president-elect proposed policy changes in many areas, not just in fiscal policy. Some proposed changes, such as plans for deregulation, seem to have been positive for business and market sentiment, but others may work in the opposite direction. For example, the possibility of new trade barriers or even trade wars concerns some businesspeople, and changes to health care policy are likely to create both winners and losers. Overall, according to the December minutes, some of the business contacts consulted by Fed policymakers “thought that their businesses could benefit from possible changes in federal spending, tax, and regulatory policies, while others were uncertain about the outlook for significant government policy changes or were concerned that their businesses might be adversely affected by some of the proposals under discussion.”

The minutes are not explicit, but it’s possible that FOMC participants also considered the international implications—and the resulting feedback effects on the US—of Trump policy proposals. For example, the Mexican peso and stock prices have already been adversely affected by concerns about prospective US trade and immigration policies. Heightened international stresses would have implications for the US growth outlook as well.

4. Asset price changes may limit the effects of a fiscal program on the pace of growth.

Financial markets are forward-looking, and, as I’ve discussed, asset prices have already built in expectations of a strongly expansionary fiscal stance in the next few years. However, the changes in asset prices themselves may partially offset the effects of the eventual fiscal program on economic growth. For example, all else equal, the increase in longer-term interest rates since the election may reduce investment spending, including home construction, and the stronger dollar could prove a headwind for exports. (On the other hand, higher equity prices would tend to support higher rates of consumer and business spending.) In the Fed staff forecasts for the December meeting, according to the minutes, the positive effects of assumed fiscal changes on growth and inflation were “substantially counterbalanced” by the restraining effects of higher longer-term interest rates and the stronger dollar.

Overall, there appear to be good reasons for the Fed to remain cautious about incorporating a major new fiscal expansion into the economic outlook, and thus anticipating more-rapid increases in short-term interest rates than previously projected. Because of uncertainty about the timing, size, and composition of the fiscal package, and the resulting uncertainty about its likely economic effects, Fed policymakers are, for now, sticking to their baseline forecast and treating a big fiscal program as an “upside risk.” As the outlines of the Trump administration’s fiscal policy become clear, the Fed’s projections—and its actual policy—will adjust accordingly.

[1] Indeed, according to the minutes, only about half of the FOMC participants assumed any fiscal changes at all in their baseline projections.

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