The Fed/Trump Face-off: When Fiscal and Monetary Policy Collide

On March 15 the Federal Open Market Committee, the branch of the Federal Reserve System that makes interest rate and other monetary policy decisions, raised short-term interest rates by 0.25%. While Fed Chair Janet Yellen didn’t explicitly indicate that the Fed would become more aggressive with its timeline of raising rates, the general consensus is that further hikes are coming this year. The Fed’s dual mandate of price stability (2% inflation) and full employment are close to being achieved, and the risks lean toward rising inflation.

Meanwhile, the Trump administration set forth a path for accelerated economic growth, with a targeted 4%+ GDP growth objective — something that will be increasingly difficult to achieve as the Fed tightens monetary policy.

On the surface, these contradicting trajectories and policies might be troubling to investors — however they don’t need to be, at least not yet.

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Looking at history, one would have to go back to 1954 to identify a period when interest rates were at the current ultra-low levels. Since then, the Federal Reserve embarked on 14 different rate-hike cycles, during which the U.S. economy experienced above-average GDP growth each time. It seems counterintuitive for the U.S. economy and the stock market to out-perform their long-term averages during interest rate hike cycles, but there is a valid rationale.

It generally takes six to 12 months for monetary policy actions to take root. Any impact from an interest rate hike in March will likely not be felt by the economy until later this year or early next year. The effect may be more pronounced during the current cycle because the Fed has been very measured and cautious in its approach so far. This rate-hike cycle is probably starting on the late side of things, so economic growth momentum is pretty strong and is unlikely to be derailed quickly. Historically this is not uncommon, as the Fed tends to start its rate-hike cycle a bit too late and tends to end it a bit too late as well (which explains why the economy and stock market tends to underperform in the year following the end of a rate-hike cycle).

Conversely, deregulation and expectation of tax reform have a very rapid impact on investors’ psychology and business sentiment. The Trump administration has already changed the regulatory environment through several executive orders, and given that Congress is controlled by Republicans, more legislative action is likely. This should have an almost immediate impact on business sentiment and, therefore, business investment. Furthermore, the prospect of tax reform — both on a corporate and individual level — is likely to further entice spending.

In other words, the Fed’s action will take some time before it affects the economy, while the Trump administration’s actions will be felt much more rapidly.

This is not the end of the story. Investors should be aware that there are many other fiscal and monetary policy tools available to the administration and the Federal Reserve respectively. For now, the Fed is remaining patient while the administration is deploying its “rapid-fire” policies. This means the U.S. economy can be expected to continue to grow at a solid pace with strong corporate earnings growth — currently expected to rise by 10% for the calendar year. Consequently, the markets are reaching new highs. However, if the economy begins to heat up too quickly or inflation rises more than desired, the Fed has many tools available to quickly cool the economy.

For those who are worried about a derailing of the economy, pay close attention to the tools the Fed deploys. Raising interest rates alone should continue the bullish trend, but changing the bank reserve requirements or significant intervention in foreign currency operations could signal a more volatile economic environment and spell trouble for investors.

Likely Winners:

• Financial firms (deregulation) and savers (higher rates)
• Energy companies (deregulation)
• Domestic exporters (weaker dollar)
• Insurance companies (deregulation)

Likely Losers:

• Borrowers (higher rates)
• Retailers (higher rates / over $3 trillion in outstanding debt)
• Foreign producers (new trade agreements)
• Insured Americans (higher premiums / loss of coverage)