MNI ANALYSIS: Untimely Stimulus Could Catch Fed on Back Foot

By Jean Yung

     NEW YORK (MNI) - Federal Reserve officials might find themselves caught on

the back foot if they fail to stay ahead of Donald Trump's expansionary fiscal

policy and, in playing catch-up, choke off the decade-long expansion.

     At a time when Wall Street analysts are forecasting stronger growth and

inflation in response to tax reform and the new federal budget, U.S. central

bank officials remain focused on lessons from the post-crisis period and ways to

enhance their recession-fighting toolkit.

     At the annual Monetary Policy Forum sponsored by the University of Chicago

Booth School of Business on Friday, New York Fed President Bill Dudley and

Boston Fed chief Eric Rosengren defended the Fed's $3.5 trillion of bond

purchases in the wake of the Great Recession, saying the Fed would likely resume

large-scale asset purchases if economic developments force interest rates back

to zero.

     They and others have called for a review of the central bank's operating

framework in recent weeks in light of longer run issues around low real interest

rates. 

     "Although the recovery was slow in coming, the economic expansion is now

firmly in place, labor markets are strong, and inflation is expected to return

to 2% on a sustained basis over the next couple of years," Cleveland Fed

President Loretta Mester said at the conference Friday. "Nonetheless, the

post-crisis economic environment is expected to differ in some important ways

from the pre-crisis world."

     --FALLING R-STAR

     Fed research shows the so-called real neutral rate has fallen to a

historically low level, with the median longer-run federal funds rate in the

most recent Fed dot plot sitting at 2.75%. The upshot, officials say, is the Fed

is unlikely to be able to raise rates as high as in the past and won't have as

much space to lower them when a recession hits. 

     "Even a garden-variety recession" could put the Fed in a position where it

has no choice but to move rates to zero and resort to unconventional policy

tools, Dudley said Friday. Almost all recessions have resulted in the Fed

lowering nominal rates by much more than that margin, Rosengren added. 

     But stronger growth over the next few years will likely keep the expansion

going, while increased infrastructure and capital spending could support

productivity growth. If inflation rises sharply, forcing the Fed to raise rates

quickly, the risk of triggering a recession becomes more real. 

     --TRUMPONOMICS SURPRISE

     Economists inside and outside the Fed spent years imploring

Republican-controlled Congresses to use fiscal policy to stimulate the economy

amid a sluggish recovery, to little effect. Now, Congress has moved away from

fiscal austerity at a time when the U.S. economy is at full employment with no

output gap, and global growth has gained momentum.

     Indeed the minutes of the late January policy meeting -- which took place

before the budget bill's passing -- saw officials conceding the effects of the

tax legislation "might be a bit greater in the near term than they had

previously thought." 

     Yet the Fed continues to emphasize the short-lived nature of the stimulus,

noting the bulk of the impact should be felt this year with less impact in 2019

and 2020. If inflation climbs faster than expected, higher rates may be needed

sooner. 

     As Dallas Fed chief Rob Kaplan pointed out last week, "History suggests

that if the Fed waits too long to remove accommodation at this stage in the

economic cycle, excesses and imbalances begin to build, and the Fed ultimately

has to play catchup." 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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