Delivering her first speech on monetary policy since September, closely watched Fed governor Lael Brainard, considered to be one of Janet Yellen's most trusted peers, said monetary policy "could be affected for some time by uncertainty surrounding fiscal policy and its effects on the economy", specifically the magnitude, timing and composition of these changes.
And while the Fed's recent shift to incorporate the "Trump stimulus" in its forecasts has been duly noted, and according to some has made the Fed more hawkish as the central bank expects substantial stimulus even with employment near capacity (granted, ignoring the 95 million Americans out of the labor force), Brainard on Tuesday took a modest step back and acknowledged that while expansionary fiscal policy could prompt the central bank to undertake a faster pace of interest rate increases and begin shrinking its balance sheet sooner than expected, the details of the policy shifts under Donald Trump are still quite uncertain and could come at "significant costs."
In other words, the Fed may bypass the near-term impact of the Trump stimulus, and focus on the longer-term, more adverse and deflationary implications by what the president-elect will unveil. Translation: no hikes even as inflation rises "transitorily." This may be the Fed's first admission that it could stay pat, and not hike even if Trump manages to push through his proposed $1 trillion stimulus.
Still, she conceded that fiscal stimulus that targets households and businesses that are likely to spend and invest rather than save will raise aggregate demand. That can speed recovery when the economy far from full employment and price stability, but at this point, it will "more likely result in inflationary pressures," she said in remarks prepared for the Brookings Institution in Washington. That is because data shows full employment is "within reach" and there are "signs of gradual progress toward our inflation target."
At this point the discussion shifted to another topic near and dear to the Fed's heart: what kind of fiscal stimulus will Trump unveil.
"Fiscal expansions that affect only aggregate demand and are enacted when the economy is near full employment and 2 percent inflation are relatively less likely to sustainably boost economic activity and relatively more likely to be accompanied by increases in interest rates."
At the same time, she warned, because these policies do not affect the economy's long-term growth potential "but do result in persistent fiscal deficits, they can lead to substantial increases in the debt-to-GDP ratio," reducing "the space for fiscal policy to stabilize the economy in the event of future adverse shocks."
Yes, we also found it amusing that the Fed continues to warn about America's rising debt load.
There is good news. If changes in fiscal policy raise productivity growth or induce greater labor force participation with higher levels of skill and education in the workforce could boost investment and consumption and the long-run neutral rate.
If "fiscal policy changes lead to a more rapid elimination of slack, policy adjustment would, all else being equal, likely be more rapid than otherwise," she said, "with the conditions the FOMC has set for a cessation of reinvestments of principal payments on existing securities holdings being met sooner than they otherwise would have been.
Another important dimension of fiscal policy shifts worth considering is the weak state of domestic demand in the rest of the world. Risks remain tiled to the downside, as interest rates in Japan and the euro
zone are still near zero, China faces capital outflow pressures and high levels of corporate debt, and the European banking sector remains fragile.
"If more expansionary fiscal policy here at home raises expectations of a growing divergence between the United States and other economies, upward pressure on the exchange rate will likely result, as we have seen recently with the renewed increase in the dollar."
The result could be a reduction in the effect on real economic activity at home and a drag on inflation as the dollar strengthens.
Another observation: the Fed is increasingly worried about the impact of the strong dollar on the US economy. A 20% rise in the dollar over 2014 and 2015 coincided with falling real exports and import prices, with net exports subtracting more than a half percentage point from GDP growth in both 2014 and 2015, Brainard cited.
"Against this uncertain backdrop, monetary policy will continue to be guided by actual and expected progress toward our goals, the level of the neutral rate, and the balance of risks," she concluded.
"A gradual approach will remain appropriate as long as inflationary pressures remain muted, the economy remains short of our objectives, the neutral rate remains low, and downside risks from abroad remain, although this will depend on the fiscal trajectory, as it evolves, and its uncertain effects on the economy and financial markets."
In short: the Fed and Trump's fiscal policies remain tied at the hip, with the Fed increasingly uncertain what the future may bring, which is to be expected, since even Trump overnight flip-flopped on what until recently, was expected to be one of the mainstays of his tax reform, namely the Border-Tax Adjustment. It is unclear how Congress will react to this snubbing by Trump, and whether it jeopardizes any or all of Trump's proposed stimulus plans.