MNI INTERVIEW: 2024 Fed Hikes Possible On Fiscal Boost-Kaplan

Federal Reserve officials can afford to keep rates on hold through the end of this year but could deliver additional increases in early 2024 if inflation proves more stubborn than they expect, particularly as fiscal policy remains unusually stimulative, former Dallas Fed President Robert Kaplan told MNI.

“I’d be hopeful that the disinflationary process will continue but I’d be leaving open the option that we might have to do more, unlikely in December, more likely into next year,” Kaplan said in an interview.

U.S. Treasury yields jumped to 16-year highs around 5% last month before receding somewhat. That represents a significant tightening of financial conditions that, combined with the lagged effects of policy, will slow an economy that continues to outpace expectations, Kaplan said.

At the same time, lingering impulses from various rounds of fiscal stimulus are contributing to a USD1.7 trillion budget deficit, the largest ever excluding the Covid period. That’s having the countervailing effect of bolstering demand even as the central bank attempts to curb it.

“Why might (they) have to do more? You’ve got a highly accommodative fiscal policy. It helps explain why the consumer and the job market are as resilient as they’ve been,” he said. Fed Chair Jerome Powell “went through great pains to be hopeful but to be clear that they’re keeping the option open if they have to do more.”

For now, the Fed can afford to proceed with caution and keep rates steady as it assesses the extent of financial tightening from the surge in bond yields – and its possible financial stability implications.

It can also wait for what are sure to be continued lagged effects from its policies, especially in parts of the economy like housing and some business loans that have benefited from fixed rates, Kaplan said. (See MNI POLICY: Fed Convinced Past Hikes' Full Effect Still To Hit)

Chair Powell “went through great pains to be hopeful but to be clear that they’re keeping the option open if they have to do more.”

FISCAL MISSING LINK

Kaplan thinks much of the spending from the Inflation Reduction Act, and even lingering funds from the nearly USD5 trillion in fiscal stimulus delivered in response to the pandemic, continue to filter through to the economy as many consumers and businesses find themselves still flush with cash and thus fairly insulated from rate increases.

He has long argued the U.S. government's fiscal largesse is working at cross purposes with monetary tightening.

“The jury is out to me whether the Fed by itself can get inflation down to 2%. I think by itself the Fed can get inflation to 3% or a little below, but I think you may need a broader set of activities in addition to the Fed to actually get inflation to 2%,” he said.

REFUNDING STRUCTURE

The importance of fiscal matters to the economic outlook was highlighted by the Treasury’s decision to frontload its bond auction schedule.

“That might have been the most important decision made yesterday” despite the market sensitivity of the Fed meeting itself, Kaplan said.

Kaplan says he’s still skeptical about whether the neutral rate of interest has risen, as some inside the Fed speculate. (MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)

“The organic strength of the U.S. economy does not suggest to me that r-star is higher. My concern would be unless we get a big pop in productivity, I’d be worried that some of the strength in the economy is artificial induced by very highly accommodative fiscal policy,” he said.

QT DRIVING YIELD SPIKE

Kaplan thinks the spike in long-term yields is more closely related to the Fed’s ongoing shrinkage of its balance sheet than Fed officials are willing to publicly concede.

“It’s possible that the balance sheet runoff in the last three months has had more impact on the transmission to tighter financial conditions than the fed funds rate. I know the fed funds rate is the primary tool but in the last three months the balance sheet runoff has had a significant impact,” he said.