The end of the Trump rally?

I generally don’t think I can beat the market, however, right now there is something, which worries me and that is that the “Trump rally” in the US stock market could be about to end.

It seems to me that what US stock market investors are really focusing on is the potential for deregulation and tax cuts (and infrastructure investments). And we might of course get that and deregulation and tax cuts and certainly should be welcomed news both for the US economy and the US stock markets.

But if you get supply side reforms then it will be because of the Republican majority in the House and the Senate (might) want this – not because of Trump. Trump continues to pay lip service to these ideas, but he has certainly not be consistent. There is nothing in Trump’s past that tell us that he is a “free market guy”.

Where he has been consistent – even very consistent – is on his protectionist message and his China bashing. Presently the markets are ignoring this and that might not be the wrong thing to do, but I must say Trump’s 35% tariff talk scares scares me a lot and so does his persistent attempt to “pick a fight” with China.

Another factor, which could spell the end of the “Trump rally” is that not only will the Federal Reserve hike interest rates next week, but the FOMC could also send a more hawkish signal than presently being priced by the market.

In this regard I would particularly focus on inflation expectations, which essentially have stopped rising since 5-year/5-year breakeven inflation expectations broke above 2% a couple of weeks ago. Meanwhile the US stock markets generally has continued to trade (moderately) higher. To me that there seems to be a bit of a disconnect.

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Hence, investors expected some Trumpflation as long as (medium-term) inflation expectation, where below 2%, but from here on investors are likely to increasingly think that there will be full monetary offset of any “fiscal stimulus” from the Trump administration.

So did I just say that the “Trump rally” might soon come to an end? I don’t know and I am not giving investment advice here, but…

John Allison just endorsed NGDP targeting

On Monday Donald Trump met with John Allison the former CEO of the BB&T and former CEO of the libertarian think tank The Cato Institute.

It has been suggested that Allison might be in the running to become new US Treasury Secretary.

Allison is widely known to be an staunch advocate of deregulation of the banking sector and in favour of a rule-based monetary policy. Many had taken his support for a rule-based monetary policy to mean that he favours a gold standard.

However, Allison ultimately would like to see a Free Banking system in the US, but also acknowledges that that is not realistic anytime soon. Instead watch what he says on this interview on Fox & Friends.

“We need discipline, we need somekind of rule, I like the Taylor rule, I like some kind of GDP indexing rule…”

There you go – John Allison who might become next US Treasury Secretary just endorsed Nominal GDP targeting.
Further than that Allison obviously strongly supports scaling back Dodd-Frank. Something I also strongly believe in.
So concluding, if John Allison supports NGDP targeting and significant deregulation of the financial sector I would  – for what it is worth -endorse him as US Treasury Secretary anytime and it certainly helps that I know that he would be strongly against any protectionist measures presently being discussed by the Trump camp.
HT George Selgin.

PS If I had been John Taylor I might chosen the title “John Allison just endorsed the Taylor rule” and that would have been equally correct. The point is that we now have a potential future US Treasury secretary who is open-minded and well-informed enough to serious be thinking about NGDP targeting. That is good enough for me.

Highland Capital's Tom Stemberg Speaks On Economy At The National Press Club

Themes and Scenario for 2017

At Markets & Money Advisory we have tried to think a bit about different themes and scenarios for the global economy and markets in 2017. What is more likely? We don’t know and this is not investment advice, but it might help investors and policy makers to think about risks and opportunities.

I you want to know more about Markets & Money Advisory’s research agenda and research products please contact me Lars Christensen (LC@mamoadvisory.com).

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Stephen Bannon – Nationalist Keynesian

This is president-elect Donald Trump’s Senior Counsel Stephen Bannon:

I’m not a white nationalist, I’m a nationalist. I’m an economic nationalist…

…Like [Andrew] Jackson’s populism, we’re going to build an entirely new political movement….It’s everything related to jobs. The conservatives are going to go crazy. I’m the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything. Ship yards, iron works, get them all jacked up. We’re just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution — conservatives, plus populists, in an economic nationalist movement.

Something is seriously wrong with a guy saying “as exciting as the 1930s”, but it is yet another confirmation that the Trump administration is likely to pursue rather vulgar Keynesian policies. It can’t be long before Paul Krugman is offered a job in the new Trump administration.

 

The Trump-Yellen policy mix is the perfect excuse for Trump’s protectionism

It is hard to find any good economic arguments for protectionism. Economists have known this at least since Adam Smith wrote the Wealth of Nations in 1776. That, however, has not stopped president-elect Donald Trump putting forward his protectionist agenda.

At the core of Trump’s protectionist thinking is the idea that trade is essentially a zero sum game. Contrary to conventional economic thinking, which sees trade as mutual beneficial Trump talks about trade in terms of winners and losers. This means that Trump essentially has a Mercantilist ideology, where the wealth of a nation can be measured on how much the country exports relative to its imports.

Therefore, we should expect the Trump administration to pay particularly attention to the US trade deficit and if the trade deficit grows Trump is likely to blame countries like Mexico and China for that.

The Yellen-Trump policy mix will cause the trade deficit to balloon

The paradox is that Trump’s own policies – particularly the announced major tax cuts and large government infrastructure investments – combined with the Federal Reserve’s likely response to the fiscal expansion (higher interest rates) in itself is likely to cause the US trade deficit to balloon.

Hence, a fiscal expansion will cause domestic demand to pick up, which in turn will increase imports. Furthermore, we have already seen the dollar rally on the back of the election Donald Trump as markets are pricing in more aggressive interest rate hikes from the Federal Reserve to curb the “Trumpflationary” pressures.

The strengthening of the dollar will further erode US competitiveness and further add to the worsening the US trade balance.

Add to that, that the strengthen of the dollar and the fears of US protectionist policies already have caused most Emerging Markets currencies – including the Chinese renminbi and the Mexican peso – to weaken against the US dollar.

The perfect excuse

Donald Trump has already said he wants the US Treasury Department to brand China a currency manipulator because he believes that China is keeping the renminbi artificial weak against the dollar to gain an “unfair” trade advantage against the US.

And soon he will have the “evidence” – the US trade deficit is ballooning, Chinese exports to the US are picking up steam and the renminbi continues to weaken. However, any economist would of course know that, that is not a result of China’s currency policies, but rather a direct consequence of Trumponomics more specifically the planed fiscal expansion, but Trump is unlikely to listen to that.

There is a clear echo from the 1980s here. Reagan’s tax cuts and the increase in military spending also caused a ‘double deficit’ – a larger budget deficit and a ballooning trade deficit and even though Reagan was certainly not a protectionist in the same way as Trump is he nonetheless bowed to domestic political pressures and to the pressures American exporters and during his time in offices and numerous import quotas and tariffs were implemented mainly to curb US imports from Japan. Unfortunately, it looks like Trump is very eager to copies these failed policies.

Finally, it should be noted that in 1985 we got the so-called Plaza Accord, which essentially forced the Japanese to allow the yen to strengthen dramatically (and the dollar to weaken). The Plaza Accord undoubtedly was a contributing factor to Japan’s deflationary crisis, which essentially have lasted to this day. One can only fear that a new Plaza Accord, which will strengthen the renminbi and cause the Chinese economy to fall into crisis is Trump’s wet dream.

 

We miss you Uncle Milty

10 years ago today – I was at a Christmas party with my then employer Danske Bank when we got the sad news. Milton Friedman my big hero had died.
I remember my parents telling me the next day that they had heard the news on TV. My dad had asked my mom whether they should call me about the sad news. Mom told my Dad “No, he is out for a Christmas party lets not ruin his night”. That is good parents – they were thinking of their then 35 year old son’s well-being, but it probably is also telling just how much Friedman meant and still means to me.
Milton Friedman is dearly missed. He would have spoken out against the nonsense central bankers continue to come up with and he would be in the forefront speaking out against Trump’s protectionist nonsense.

Update: My good friend Sam Bowman has a very good post on the Milton Friedman Agenda. See also Madsen Pirie video on Friedman here. It is easy to be proud of being part of the Adam Smith Institute family today.

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Lessons for today: The conflict between Reagan and Volcker

This is from the The New York Times on February 17 1982:

President Reagan and the chairman of the Federal Reserve Board, Paul A. Volcker, met Monday to discuss monetary and budget policy, Administration officals confirmed today…

… The official said that the meeting covered a broad range of economic issues, including monetary policy and budget deficits. But, the official said, the main reason for the session was to reinforce the ”personal relationship” between the two men. The two last met in December.

The meeting comes after recent tension between the Fed and the Administration, highlighted by the Administration’s contention that the Fed’s erratic management of the money supply was pushing up interest rates and Mr. Volcker’s response that it is the threat of large budget deficits that is affecting interest rates.

…Many economists outside the Government say that the Fed and the Administration are on a collision course on economic policy because the tight monetary policy promised by the Fed will not allow for the relatively strong economic growth the President has forecast will begin by the second half of this year.

Mr. Volcker in an interview Sunday said that he did not think the economy would come ”roaring” back, as Treasury Secretary Donald T. Regan predicted recently. In testimony last week before Congress, the Fed chairman also said he would not count on the Administration’s forecast of relatively strong economic growth for 1983.

…In response to questions about his meetings with the President, Mr. Volcker, in testimony last week, asserted his and the Fed’s independence over monetary policy. ”It is our responsibility to make up our minds about these things, and we do so. Forget about what the Administration says at the moment.”

Paul Volcker was no Arthur Burns and Reagan was no Nixon. In the case of Nixon/Burns Burns just did what Nixon demanded, while Volcker would not back down, but nonetheless avoided all out “war” between the Reagan administration and the Fed and Reagan understood that it was the right thing to do was to (mostly) respect the Federal Reserve’s independence. That said, the policy mix was very bad during Reagan’s two terms as president.

How will story play out between Yellen and Trump in 2017-18?

Donald Trump will replace Janet Yellen with a DOVE in 2018

Some have suggested that when Janet Yellen’s term as Federal Reserve chair expires in 2018 then Donald Trump will try to replace her with a more “hawkish” chairman. Some even has suggested that he could try to re-introduce the gold standard and appoint the king of monetary policy rules John Taylor as new Fed chairman.

I, however, believe that is completely wrong. Donald Trump doesn’t care about the Gold Standard (luckily) and certainly he does not care about a rule-based monetary policy.

The fact is that Trump’s entire policy agenda is inflationary. On the supply side his anti-immigration stance will push up US labour cost and this protectionist agenda will push up import prices.

On the demand side his call for underfunded tax cuts and massive government infrastructure investments also increase inflationary pressures.

So if unchecked (should write un-offset by the Fed?) Trump’s economic policy agenda will push inflation up. However, Trump does not – yet – control monetary policy and if the Federal Reserve is serious about it’s 2% inflation target it sooner or later will have to offset the Trumpflationary policies by hiking interest rates potentially aggressively and allow the dollar to strengthen significantly.

I have argued (see here and here) that initially the Federal Reserve will welcome a “fiscal boost” to support aggregate demand as the Fed for some odd reason is not willing to use monetary policy to hit the 2% inflation target. However, the alliance between the Trump administration and the Federal Reserve could be short-lived if inflation expectations really start to take off.

So in a situation where the Fed moves to hike interest rates more aggressively – for example in the second half of 2017 or in early 2018 it will become clear even to Trump that the Fed is “undermining” his promise of doubling US growth and “create millions of jobs”.

That could very well create a conflict between the Fed and the Trump administration and it is very likely that Trump will accuse Yellen of have too tight a monetary policy. Furthermore, with mid-term elections due in 2018 the Republicans in the Senate and the House are unlikely to be cheering for a “growth killing” tightening of monetary policy.

As I have repeated on the social media over the last couple days – the GOP is (deflationary) “Austrians” when they are in opposition and (inflationary) “Keynesians” when they are in power – they never really favour monetarist and rule-based policies.

After all it was Richard Nixon who famously said “we are all keynesians now” – or rather this is how Milton Friedman interpreted what Nixon said.

Nixon of course had the utterly failed Fed chair Arthur Burns (see more on Burns and Nixon here) to do the dirty work of easing monetary policy when monetary policy already was far too easing.

If Trump reminds me of any US president it is Nixon. So why should we believe Trump would replace Janet Yellen with John Taylor when he can find his own Arthur Burns to help him support his agenda with overly easy monetary policy ahead of the 2020 presidential elections?

If this hypothesis just has a small probability of being right then the market certainly is right is to price in higher inflation during a Trump presidency. I certainly hope I am totally wrong.

PS for a discussion of Nixon and Burns’ relationship seen Burton Abrams very good (and scary) paper How Richard Nixon Pressured Arthur Burns: Evidence From the Nixon Tapes.

PPS Paul Krugman once called for Ben Bernanke to show up for a FOMC press conference in a Hawaii shirt to signal that he would be “irresponsible” and thereby push inflation expectations up and lift interest rates from the ZLB. Maybe Trump is that Hawaiian shirt.

“Make America Keynesian Again” part 2

In yesterday’s blog post I wrote about why I believe it is the combination of Donald Trump’s fiscal stimulus plans (infrastructure investments and tax cuts) combined with the Federal Reserve’s willingness not to (fully) offset this, which has pushed inflation expectations in the bond markets up very significantly since Tuesday.

If the Fed’s inflation target was fully credible fiscal stimulus would be fully offset by the expectations of a tightening of monetary policy to “neutralize” the impact on aggregate demand from fiscal stimulus. This of course is known as the so-called Sumner Critique.

I would normally think that the Sumner Critique would hold and announced fiscal stimulus or fiscal contraction would not impact inflation expectations. This is for example what I argued in 2012 and 2013 in relationship to the so-called fiscal cliff (see here, here and here).

That argument of course turned out to be completely right – the fiscal contraction did not cause inflation expectations to drop and the US economy did not fall into recession contrary to what was argued buy arch-Keynesians such as Paul Krugman.

However, as I have often argued the causality in the economy as well as the impact of fiscal shocks depend critically on what kind of monetary policy rule the central bank has (see fore example here, here, here and here).

The standard textbook example is the Flemming-Mundell model where the budget multiplier is zero in a free floating exchange rate regime, but positive (“keynesian”) in a fixed exchange rate regime.

The important point in relationship to the expected fiscal easing from the Trump administration is that the Federal Reserve explicitly have called for the kind of fiscal stimulus that Trump now wants to deliver meaning that the Fed effectively have signaled that they will not fully offset the impact on aggregate demand.

Furthermore, it is clear that the Fed has a preference for higher nominal interest rates – disregarding the level of inflation expectations. The Fed simply don’t like interest rates at this level. However, the Fed also realizes that it is not really possibly both to deliver higher inflation than presently (which is necessary to hit the 2% inflation target) and increase interest rates. But they can get both by allowing fiscal policy to increase aggregate demand.

This, however, necessitates that the Fed will not increase interest rates quite as fast as the rise in the equilibrium interest rates caused by easier fiscal policy. This means that the Fed effective will need to peg the interest rate level.

Trumponomics in A simple IS/LM model with two different policy rules

These consideration have made me think about how to illustrate this in a simple model that even first-year economics students can understand.

That model is a rudimentary IS/LM model. While drawing with my 6-year old son tonight I put the equations on a paper (yes, I know am sometimes a nerdy dad…).  Here they are:

ISLM model Trump.jpg

What we have here is two equations. One for aggregate demand (AD) and one for money demand as well as a monetary policy rule – or rather three different monetary policy rule.

Equation (1) simply says that aggregate demand is composed of private spending/investment, which dependent on the interest rate level (r) and of government “spending”. Higher interest rates causes private spending/investment to drop.

Equation (2) is a standard textbook money demand function, where money demand (m) depends on nominal GDP (P*Y) and the interest rate level. Higher interest rates causes money demand to drop.

In the standard IS/LM model we use this to construct the LM and the IS curves. However, we also need some monetary policy rules. Introducing a monetary policy rule is what I earlier has termed a IS/LM+ model (See here and here).

The two policy rules for the Fed I here look at is an interest rate target rule – (3)’ – and a nominal GDP target rule – (3)”.

In the interest rates targeting case we simply assume that the Fed will increase (decrease) the money base (m) if the interest is higher (lower) than the interest rate target (rT). If the coefficient lambda is set to be equal to infinity it means that the Fed will not accept any change in the interest rate from the target.

Our nominal GDP target rule (3)” essentially works in the same way. If nominal GDP is below (above) the target then the money base is increased (decreased) to push up (down) nominal GDP.

We can also illustrate this with graphs – again a bit from the kitchen table:

Graphs Trump fiscal easing.jpg

 

Lets first start in the standard IS/LM model. Here fiscal easing – higher g in the model and in real-life it is Trump’s tax cuts and infrastructure investments – causes the IS curve to shift to the right.

This pushes up nominal GDP. In fact in the textbook prices are assumed to be fixed so P=1. We don’t have to make that assumption here. The increase in g also push up the interest rate (r) because it in the standard IS/LM model is assumed that the money base (m) is fixed. In the graphs above this is the move from 1 to 2.

The NGDP rule – full crowding out of Trump’s fiscal easing

However, if we have an NGDP rule we will see that nominal GDP (PY) has now been pushed above the NGDP target. This will cause the Fed to reduce the money base (m) and the Fed will continue to reduce the money base until NGDP is back on target. This causes the LM curve to shift to the left – the the lower graph that is the shift from 2 to 3 causing a further increase in interest rates.

This increase in interest rates will – see equation (1) – cause private spending/investment to drop exactly as much as government spending/investment (g) has increase. Said in another way we have full crowding out and the budget multiplier is zero. In this case the Sumner Critique obviously applies.

Therefore, if the Fed follows a NGDP targeting rule then this model tells us that Trump’s infrastructure investments will just crowd out private consumption and investment and hence not create the millions of jobs he has promised and it will not increase inflation.

The interest rate rule – Trump’s boom (and bust)

However, since Tuesday we have seen inflation expectations increase significantly. Just take a look at 5-year/5-year swap forward inflation expectations.

image002-2

Long-term inflation expectations are up more than a quarter of a percentage point since Tuesday morning. In fact this is the largest two-day increase in inflation expectations since April 2015. This is certainly not a small change in inflation expectations.

Therefore the markets are telling us that we should not expect full crowding out of Trump’s fiscal easing.

Lets turn to the explanation – interest rate pegging. This is what we have in the upper graph.

Trump eases fiscal policy. This pushes the IS curve from 1 to 2. This increases (nominal) GDP growth and push up interest rates.

However, if the Fed effectively has an interest rate rule then it will not try to offset the increase in GDP, but rather will try to offset the increase interest rates by increasing the money base (rather than reducing it). This is the shift in the LM curve to the right in the upper graph, which causes nominal GDP to increase further.

Obviously in real-life the Fed will not keep the interest rate completely fixed, but it might choose to increase interest rates less than the increase the equilibrium rate caused by massive fiscal stimulus.

This sounds like something out of the 1970s’ insane “keynesian” policy mistakes, but I actually think it is pretty much what Janet Yellen would like to see.

This is what she said a few weeks ago:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market.

Effectively Yellen is saying she would like to see the US economy “overheat”. Trump would like the same thing and the markets understand that.

The coming conflict between Stanley Fischer and Donald Trump

I overall think that these very simple models pretty well discuses the connection between monetary policy (rules) and fiscal policy and how different rules can significantly impact how the US economy response to Trump’s planned fiscal stimulus.

And I am mostly inclined to think that the Fed will implicitly collude with the Trump administration to create exactly the kind of high-pressure economy that Yellen was talking about and hence in the next couple of months we might want to think about the US economy as the interest rate targeting case in my model.

However, it is also very clear that anybody who remembers the 1960s and particularly the 1970s knows that this could be an extremely dangerous strategy. In fact Fed Vice Chairman Stanley Fischer has already warned against it.

This is what Fischer said a couple of weeks ago:

“If you go below the full employment rate, or peoples’ estimates of full employment, by a couple of tenths of percentage points, I don’t think there’s any danger in that…But saying we should keep going until the inflation rate shows us we’re wrong, then you’re going to change too late.”

Said in another way Fischer might be willing to go along with keeping interest rates below the equilibrium interest rate for some period, but he clearly fear that such a strategy soon could cause inflation to spike.

And I would certainly agree with him. Monetary policy in the US has certainly more or less consistently been too tight since 2008, but we have recently moved towards a more neutral monetary policy stance and the combination of Yellen’s ideas about a “high-pressure economy” and Trump’s fiscal expansion could be what pushes inflation expectations significantly above 2%.

If that where to happen I would expect Yellen and the Fed to reverse cause and start tightening monetary conditions rather aggressively. Donald Trump certainly would not like that and that might be setting us up for a conflict at some point in 2017 or 2018 between the Federal Reserve and the Trump administration.

 

“Make America Keynesian Again”

Today I was asked to do an interview with a Danish radio station about Donald Trump and about whether one could say anything positive about him or rather about his economic agenda. I declined to do the interview. I frankly speaking has nothing positive to say about Trump.

To me Donald Trump is an absolutely vile person and and his views on immigration and trade are completely the opposite of mine. However, I have also in the run up to the election in presentations and comments stressed that the presidential election from an overall financial market perspective would not be a big deal and judging from the market reaction today this indeed seems to be the case.

Reading the markets

But what exactly are the markets telling us today about the economic consequences of a Trump presidency combined with the fact that GOP now has the majority in both the House and the Senate?

First, of all we should concluded that the markets are fairly relaxed about the outcome of the election. This to me is an indication that Trump really will never be able (or seriously want to) implement many of the bizarre “promises” on trade and immigration he made during the election campaign.

Second the markets certainly do not expect the outcome of the election to cause a US recession or a global economic crisis. After all US stock markets are in fact trading in positive territory today. We get the same message from the currency markets where the dollar is little changed over the past 24 hours.

The Republican Keynesians

However, there is one market where we have seen a significant reaction to the outcome of the election and that is in the bond market. Just take a look at the graphs below.

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The first graph is the yield on 10-year Treasury bonds and the second graph is 2-year yields.

We see that the 10-yield has increased around 10bp overnight. This certainly is a significant reaction, but it is equally notable that 2-yields in fact is slightly down.

What this is telling me is that more than anything else the markets expect Trump to be an old-school Keynesian. We know that Trump has already promised to increase Federal spending on infrastructure and he has of course also promised major tax cuts. With the Republicans controlling both the House and the Senate he should be able to deliver on some of these promises.

In fact there would be nothing unusual about having a Republican president who is also a “keynesian” (yes, I know he has no clue about what that is). In fact historically public spending has grown faster under Republican administrations than under Democrat administrations. Just take a look at the graphs below.

Since the Second World War public spending has grown by around a quarter of a percent per year faster when the president has been Republican than when there has been a Democrat president.

The picture is even more clear when we look at Federal government investments:

…and on the budget deficit:

So based on history we can certainly say that Republican presidents tend to be less fiscally conservative than Democrat presidents and judging from the action in the bond markets today there is little reason to believe that Trump should be any different from former Republican presidents.

And what will Trump spend money on? There is little doubt what the markets think – infrastructure! This is from Trump’s victory speech:

We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals,” he said. “We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

And see what effect that kind of speech had on copper prices today:

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Keynesian president + Keynesian Fed chair = No monetary offset

So it seems like the markets expect Trump to push for an expansionary fiscal policy agenda and this is visible in the bond market. However, it is also notable that it is only long-term bond yields, which have increased while 2-year yields haven’t increased overnight.

That tells me that the markets do not expect the Federal Reserve to (fully) offset the impact on nominal demand from a more expansionary fiscal policy.

This effectively means that an easier fiscal policy stance will cause monetary conditions to be eased. The reason is that if fiscal policy is eased then that will push up the equilibrium interest rate level. If the Fed does not hike interest rates to reflect this then it will automatically ease monetary policy by keeping the fed funds rate below the equilibrium interest rate.

This of course is the standard result in a New Keynesian model when interest rates are at the Zero Lower Bound (see for example here).

Does this mean that the so-called Sumner Critique does not apply? According to the Sumner Critique an easing of fiscal policy will not have (net) impact on aggregate demand if the central bank has an inflation target (or a nominal GDP) as the central bank will act to offset any impact on aggregate demand from a easier fiscal policy.

However, the Sumner Critique does not necessarily apply if the central bank’s inflation target is not credible and/or central bank is not willing to “enforce” it. And this seems relevant to the present situation. Hence, US core inflation continue to be below the Fed’s inflation target so one can certainly argue that there is room for an increase in aggregate demand without the Federal Reserve having to tighten monetary conditions.

Obviously the Fed could have done this on it own by for example not signaling a rate hike in December or signaling that it would re-introduce quantitative easing if inflation once again started to trend downwards.

However, the Fed clearly has “mental” problems with this. It is clear that most key Fed policy makers are worried about the consequences of keeping interest rates “low for longer” and more QE clearly seems to be a no-go.

In other words the Fed has put itself in a situation where further monetary easing is off the table and this is of course the reason why a number of Fed officials in the last couple of months have called for old-school keynesian fiscal stimulus.

It all seems to have started in August. This is Janet Yellen at the Jackson Hole symposium on August 26:

Beyond monetary policy, fiscal policy has traditionally played an important role in dealing with severe economic downturns. A wide range of possible fiscal policy tools and approaches could enhance the cyclical stability of the economy.25 For example, steps could be taken to increase the effectiveness of the automatic stabilizers, and some economists have proposed that greater fiscal support could be usefully provided to state and local governments during recessions. As always, it would be important to ensure that any fiscal policy changes did not compromise long-run fiscal sustainability.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans’ living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

“Promoting capital investment” of course means government infrastructure spending.

Since August we have heard this again and again from Fed officials. This is Federal Reserve Vice Chairman Stanley Fischer at the New York Economic Club on October 17:

Some combination of more encouragement for private investment, improved public infrastructure, better education, and more effective regulation is likely to promote faster growth of productivity and living standards.

Said in another way – the Fed chair and the Vice chairman are both old-school keynesians and now we will have a keynesian in the White House as well.

The consequence is that if we get massive government infrastructure investments then that will push up the equilibrium interest rate, which will allow the Fed to hike interest rates (which they for some reason so desperately want to) without really tightening monetary conditions if interest rates are increased slower than the increase in the equilibrium rate.

This means that we de facto could have a keynesian alliance between the Trump administration and the Federal Reserve, which would mean that will get both monetary and fiscal easing in 2017 and this might be what the markets now are realizing.

Just take a look at what have happened in 5-year/5-year inflation expectations over the paste 24 hours:

image001-1

Over the past 24 hours long-term inflation expectations hence have increased by nearly a quarter of a percentage point.

Hence, Donald Trump just eased US monetary conditions significantly by pushing down the difference between the Fed fund target rate and the equilibrium rate. Paul Krugman should love Donald Trump.

The Sumner Critique strikes back – A future conflict between the Fed and Trump?

Obviously this is only possible because the Federal Reserve has not been willing to ensure nominal stability by clearly defining its nominal target and has been overly eager to increase interest rates, but I do think that this keynesian stimulus implemented could increase aggregate demand in 2017 and likely push core inflation above 2%.

But if this happens then the keynesian alliance between the Federal Reserve and Trump Administration might very well get tested. Hence, if fiscal-monetary easing push unemployment below the natural rate of unemployment and inflation (and inflation expectations) start to accelerate above 2% then the Federal Reserve sooner or later will have to act and tighten monetary conditions, which could be setting the US economy up for a boom-bust scenario with the economy initially booming one-two years and then the Fed will kill the boom by hiking interest rates aggressively.

Knowing Trump’s temperament and persona that could cause a conflict between the Fed and the Trump administration.

This is of course pure speculation, but even though the Trump administration and the Fed for now seem to favouring the same policy mix – aggressive fiscal easing and gradual rate hikes (slower than the increase the in equilibrium rate) it is unlike that this kind of old-school keynesian stop-go policies will end well.

2017 – a year of inflation?

Given these factors and others I for the first time since 2008 think that we could see inflation increase more significantly in 2017 in the US. This is of course what we to some extent want, but I am concerned that we are getting higher inflation not because the Federal Reserve has moved towards a more rule-based monetary policy framework, which ensure nominal stability, but because we are moving back towards old-school keynesian stop-go demand “management”.

PS I apologize to serious (New) Keynesians about using the term “keynesian” here. I here use the term as to refer to the kind demand management policy, which so failed during the 1970s. They where inspired by Keynesian economic think and was as such keynesian. However, that is not say that present day keynesians would necessarily agree with these policies.

PPS See also my comment over at Geopolitical Intelligence Service on why the US is “Still the Greatest”– also after Trump has become president.

Update: Read my follow-up post here.

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