WHAT TO EXPECT FROM THE FED IN 2017

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1 Legg Mason Thought Leadership WHAT TO EXPECT FROM THE FED IN 2017 John Bellows, PhD Portfolio Manager/Research Analyst The Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communi cations will likely have a hawkish tilt this year. Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates. The relationship between the White House and the Fed is a wildcard, but doesn t necessarily have to be contentious This document reflects the opinions, views and analysis of Western Asset regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal. This material is only for distribution in those countries and to those recipients listed. Please refer to the disclosure information on the final page. FEB 2017 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 JOHN L. BELLOWS, PhD Portfolio Manager / Research Analyst POLICY MATTERS Executive Summary The outlook for the Fed is highly dependent on the prospect of a new policy environment, which has led to a rethinking of economic forecasts and significant repricing across asset classes. We believe the Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communications will likely have a hawkish tilt this year. Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates. The relationship between the White House and the Fed is a wildcard, but doesn t necessarily have to be contentious. Introduction The surprise election of Donald Trump continues to be the focus for investors. The prospect of a new policy environment, and the various attendant risks, have led to a rethinking of economic forecasts and significant repricing across asset classes. The outlook for the Federal Reserve (Fed) is, of course, highly dependent on how this new policy environment develops, and how the various risks will be navigated. Rather than attempting to map out how monetary policy will evolve under the myriad number of possible outcomes, this note sets out a more modest goal of making three general observations about the Fed that we think will be relevant this year: The Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communications will likely have a hawkish tilt this year. Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates. The relationship between the White House and the Fed is a wildcard, but doesn t necessarily have to be contentious. 1. The Fed intends to offset fiscal stimulus with tighter monetary policy, and as a consequence Fed communications will likely have a hawkish tilt this year. Since the election there has been a marked increase in investor optimism, as is apparent in sentiment surveys and in a range of financial market prices. The prospect of a pro-business White House relaxing the regulatory environment has been a key driver of the shift in sentiment. In addition, many expect that lower taxes and higher government spending will boost near-term growth, although the magnitude is a subject of debate and is dependent on the details. Optimists also argue that easier fiscal policy could shift the burden from monetary policy to fiscal policy, thereby leaving the US with a more sustainable balance between the two. A final reason for optimism is the prospect for improved productivity and consequently a higher level of longer-run growth for the US economy. As members of the Fed form their own expectations and plans for the coming year, we suspect there will be a consensus on the appropriate response to a realization of easier fiscal policy: tighter monetary policy. To some extent the bias toward tightening monetary policy in order to offset optimism around fiscal policy was already apparent in the December Federal Open Market Committee meeting, when the Fed increased its median expectation for rate rises more than expected. In order to understand the Fed s determination in this regard, it s helpful to revisit the reasons for optimism listed above, and on each point note how the Fed is likely to view the implications of changes in policy. First, on lower taxes and higher spending boosting growth, the Fed would likely question whether any such boost is needed right now. The Fed s view is that the US economy is performing close to full capacity, after having made substantial progress on both the unemployment rate and the inflation outlook (Exhibit 1). Fed Chair Janet Yellen clearly had this in mind when she made the following, fairly blunt assessment: So I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment. 1 The implication of Yellen s statement is that the Fed may be inclined to offset an unneeded fiscal stimulus. 1 Press Conference, December 14, Western Asset 1

3 POLICY MATTERS John L. Bellows, PhD Western Asset Management Company Portfolio Manager / Research Analyst, 2012 U.S. Department of the Treasury Acting Assistant Secretary for Economic Policy; Deputy Assistant Secretary for Microeconomic Analysis; Senior Advisor in the Office of Economic Policy, University of California, Berkeley, PhD Economics Dartmouth College, BA Economics, Magna Cum Laude Exhibit 1 Unemployment Rate and Inflation Outlook Percent Unemployment Rate FOMC Forecast as of Dec 2014 Percent (% change over 12 months) Core PCE Inflation FOMC Forecast as of Dec Source: Federal Reserve, Bureau of Labor Statistics, Bureau of Economic Analysis. As of 30 Nov 16 Second, should fiscal policy take over some of the burden previously shouldered by monetary policy, Fed officials could view that as an opportunity to increase rates. Fed officials desire to increase interest rates has been well aired over the past few years, with its cited reasons ranging from concerns about low rates not being normal to concerns about whether the Fed would have enough ammunition to cut rates in response to an unforeseen shock. The Fed has been held back by disappointing economic data and by a concern that constraints on fiscal policy would make future shocks more damaging. Not only would the Fed welcome better economic data resulting from easier fiscal policy, but even before any changes in the data the Fed could view the risks as slightly less asymmetric because an unforeseen shock would be more likely to trigger a fiscal policy response. Finally, on the prospect for productivity improvements, the Fed is likely to be skeptical, at least at the outset. Economists often note that explaining long run changes in productivity is very difficult. By implication it s similarly difficult to have much confidence in which policy changes will meaningfully affect these trends. Certainly some of the proposed changes in fiscal policy could help, including improvements in infrastructure and lower corporate tax rates, but the size of the impact is highly uncertain. At the same time, it seems likely that at least some of the contributors to the recently low productivity will persist, limiting the extent to which productivity can rebound. Chairman Alan Greenspan famously resisted hiking interest rates in the mid-1990s, even though growth was accelerating at the time, due to his optimism on productivity growth in the US. His call was vindicated over the following few years, adding to his formidable reputation as a central banker. The current Fed is unlikely to follow Greenspan s model, and absent much more concrete evidence that productivity has indeed rebounded, the Fed would likely respond to faster growth with higher interest rates. Given the preponderance of arguments for offsetting easier fiscal policy with tighter monetary policy, and the consensus these arguments will engender within the Fed, it is likely that this theme will feature prominently in Fed communications this year. As such, Fed communications are likely to have a somewhat hawkish tilt. This would be a departure from the dovish tilt that communications have had over the past few years. Of course the Fed is also aware that a hawkish tilt in its communications influences market prices in particular the front end of the yield curve and by doing so tightens the policy stance preemptively. Whether that preemptive tightening is an opportunity or just a preview of things to come is the subject we turn to next. Western Asset 2

4 POLICY MATTERS 2. Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates. The previous section focused on how the Fed would respond to easier fiscal policy and faster growth. Importantly, this is a conditional observation. IF fiscal policy is loosened and growth picks up, THEN the Fed will likely respond by tightening monetary policy. That said, absent more concrete developments, the Fed is not under any current pressure to hike. The inflation outlook is far from threatening, there is considerable uncertainty around the size and shape of the coming fiscal changes and the new administration s policies carry a number of risks that could significantly curtail the positive aspects of looser fiscal policy. The sharp fall in inflation expectations at the beginning of last year forced the Fed to make a dovish course correction, and as a result the Fed delivered only one hike instead of the planned four. Inflation expectations have increased since the election and are currently well above their lows. That does not mean, however, that the Fed now feels pressure from the other direction. Far from it. After the recent bounce, inflation expectations now sit comfortably in the middle of their range over the past few years (Exhibit 2). So while inflation expectations are no longer constraining the Fed from hiking, neither are they motivating the Fed into accelerating the pace of hikes. Indeed, the middling level of inflation expectations suggests that a gradual pace of rate hikes is about right. Exhibit 2 10-Year Breakeven Inflation Percent Dec '15 FOMC Meeting: Market-based 1.2 measures of inflation compensation remain low." Source: Bloomberg, Federal Reserve. As of 05 Jan 17 Jan '15 FOMC Meeting: "Market-based measures of inflation compensation have declined substantially in recent months." Dec '16 FOMC Meeting: "Marketbased measures of inflation compensation have moved up considerably up but are still low." Current = 2.07% Looking forward in the inflation outlook, one often cited argument for an acceleration is that an ever tighter labor market will lead to faster wage gains. Perhaps that will happen, but such arguments assume a few facts not currently in evidence. The tightening of the labor market has moderated substantially. In 2016, the unemployment rate fell by only 0.3 percentage points, even though employers added over 150,000 jobs per month. One primary reason for the flattening out of the unemployment rate was an increase in participation among prime age workers. As our Economist Mike Bazdarich has written, the still low ratio of employment-topopulation across a wide range of cohorts suggests that this trend could continue for some time to come. Another relevant point is that the relationship between the unemployment rate and wages has been tenuous, at best, over the past few years. The downward pressure on US wages from global competition, low productivity and changes to the structure of the US labor market have outweighed the slight tightening from a falling unemployment rate. Given ongoing slack and limited responsiveness of wages to a lower unemployment rate, we are inclined to agree with Chair Yellen that overheating coming from the labor market is unlikely. 2 2 Janet Yellen, The Economic Outlook and the Conduct of Monetary Policy, January 19, 2017 Western Asset 3

5 POLICY MATTERS Nor is there enough certainty on the outlook for fiscal policy to compel the Fed to move right now. The big threshold questions are all still unanswered. What will be the mix of individual and corporate tax cuts? Will Congress approve an infrastructure plan? What will be the overall deficit impact? In addition to the big questions, the details are also crucially important. Recently two Fed officials have focused on the risks associated with changes to fiscal policy. New York Fed President Bill Dudley raised the concern that a dramatic rewriting of the corporate tax code could have unintended consequences and that the transition to a new system may not happen very smoothly. 3 Similarly, Fed governor Lael Brainard noted many risks associated with changes in fiscal policy, including the potential impact on the US dollar and concerns about debt sustainability. 4 Until there is more clarity on specifics regarding the changes to fiscal policy, such concerns are additional arguments for the Fed to wait and see. The Fed s hawkish rhetoric has clearly made an impression on investors, as now the number of hikes priced in short term interest rates is at its steepest pace since mid And yet the immediate environment does not argue for any material change in Fed policy. Not only does the inflation outlook remain unthreatening, there are multiple risks surrounding the realization and implementation of fiscal policy that may leave investors more disappointed than satisfied. Until the facts materially change on either dimension, the steepness in the front part of the yield curve provides an opportunity for investors to earn carry and roll down at arguably fair levels. 3. The relationship between the White House and the Fed is a wildcard, but doesn t necessarily have to be contentious. For perhaps obvious reasons, the topic of the relationship between the Fed and the White House has once again become top of mind, and indeed has become one of the most frequently asked questions in our recent client interactions. The reality is that the relationship is complicated. It is exceptionally hard to have much conviction on how this relationship will evolve. However, and in contrast to the many articles warning of a collision course, we d note that the initial developments are far from dire. Regardless, this will be a topic of ongoing interest and here we provide some initial thoughts on two important aspects of the relationship. The most important point of interaction will be when President Trump chooses the next Fed Chair. Janet Yellen s term as Chair ends in February 2018, and a new Chair would likely be announced sometime in the second half of this year. President Trump s preferences for the next Fed Chair are unclear. As a candidate he criticized Chair Yellen for keeping rates low, leading some to conclude that he would favor a more hawkish chair. However, on another occasion Trump said that he liked Chair Yellen because she is a low interest rate person and admitted that he, Donald Trump, is also a low interest rate person. 5 This suggested straightforwardly that Trump would favor a more dovish chair. If pushed, we re inclined to think the White House s desire to generate faster job growth will favor dovish candidates. A final point is that Trump s selection of cabinet members suggests a willingness to look outside the normal list of candidates. In the case of his selection for Fed Chair, Trump seems unlikely to choose somebody with a PhD in Economics who teaches at a top university, and instead he may gravitate towards somebody with market or business experience. As a consequence, the next Fed Chair could very well be somebody who most investors are not currently familiar with. In addition to the chair, President Trump is able to make two immediate appointments to the Board of Governors, and potentially more in later years depending on turnover. The early indications are that Trump is considering highly qualified candidates for the two vacant Board seats. The potential candidates include CEOs of community banks and a mid-size regional bank. Trump is also considering an executive at General Electric who previously worked in the government (SEC and US Treasury) and has exceptionally deep expertise on regulatory issues. 6 Any of these candidates would likely be welcomed by the Fed and by investors as credible and capable of making a substantive contribution to the monetary policy process. 3 Bill Dudley, Evolving Consumer Behavior, January 17, Lael Brainard, Monetary Policy in a Time of Uncertainty, January 17, May 5, 2016, Donald Trump on CNBC s Squawk Box 6 Trump Moving to Fill Blanks in Financial and Economic Rosters, Wall Street Journal, January 20, 2017 Western Asset 4

6 POLICY MATTERS Another question is whether the White House will try to exert influence over Fed decisions in other ways. Over the last few decades, investors have become accustomed to Fed officials asserting their independence from politics and perhaps more importantly, to White House officials largely refraining from commenting on monetary policy. Of course the sensitivities on this issue reflect a more checkered past in which White House was much more active in influencing monetary policy. In the past, the White House has tried to steer the Fed through friendly requests based on close relationships (for example, Arthur Burns relationship with President Nixon and G. W. Miller s relationship with President Carter), or in some cases by acting more forcibly to shift the Fed s stance (for example, Paul Volcker s retirement was accelerated after Reagan s Treasury Secretary James Baker appointed two governors opposed to Volcker s policy stance). It remains to be seen whether the current détente continues or whether Trump more closely resembles Nixon, Carter and Reagan in this regard. On one hand, Trump commented on Fed policy on a number of occasions during the campaign. On the other hand, the initial signals from the new administration suggest it is proceeding cautiously on this front. For example, in his Secretary of the Treasury nomination hearing, Steve Mnuchin said he would refrain from commenting on the short-term moves in the US dollar, focusing instead on the long-term trend. This was a subtle, but important distinction that should be at least somewhat comforting for the Fed to hear. There are of course many other dimensions to the relationship between the Fed and the White House. Issues to watch include: How will the White House interact with the Fed on regulatory issues, including with regards to banks where the Fed is primary regulator? How will Treasury respond if and when the Fed ends their policy of reinvesting maturing securities on their balance sheet? While there may be competing interests in any of these issues, there is also room for optimism that conflict can be avoided. The credible list of potential Fed governors and Mnuchin s careful rhetoric regarding the US dollar perhaps represent steps in the right direction. Western Asset 5

7 Investment risks The opinions and views expressed herein are subject to change and are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. All investments involve risks, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Yields represent past performance and there is no guarantee they will continue to be paid. Past performance is no guarantee of future results. Please note that an investor cannot directly invest in an index. This material is intended to provide Western Asset s overall view and is not on behalf of any specific product or portfolio. Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Currencies and commodities contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. A credit rating is a measure of an issuer s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor s, Moody s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see or for details. DEFINITIONS: The Federal Open Market Committee (FOMC) is a policymaking body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. The U.S. Federal Reserve, or Fed, is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. A basis point is one-hundredth (1/100, or 0.01) of one percent. Gross Domestic Product ( GDP ) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities. A current account balance summarizes the flow of goods, services, income and transfer payments into and out of a country High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues. Investment grade is a level of credit rating for stocks regarded as carrying a minimal risk to investors. The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting A spread is the difference in yield between two different types of fixed income securities. A credit rating is a measure of an issuer s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor s, Moody s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see or for details. Illiquidity describes a situation in which a security or other asset cannot easily be sold or exchanged for cash without a substantial loss in its value. The federal funds rate is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans. The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. The breakeven inflation rate is a measure of expected inflation derived from nominal Treasury securities and their real counterparts inflation-protected securities.

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