What Lies Ahead for the Federal Reserve

A recent speech by Janet Yellen gives us a very clear idea of what lies ahead for the U.S. economy and the Federal Reserve during the next (and already overdue when looking at averages) recession.  The speech, given on October 20, 2017, was entitled "A Challenging Decade and a Question for the Future" looks at the Fed's progress in defeating the Great Recession over the past decade and how the Fed will fight future economic contractions.

Let's look at some key quotes from her speech starting with her rationale for using unconventional monetary policies during and after the Great Recession and the effectiveness of these policies::

"A substantial body of evidence suggests that the U.S. economy is much stronger today than it would have been without the unconventional monetary policy tools deployed by the Federal Reserve in response to the Great Recession. Two key tools were large-scale asset purchases and forward guidance about our intentions for the future path of short-term interest rates. The rationale for those tools was straightforward: Given our inability to meaningfully lower short-term interest rates after they reached near-zero in late 2008, the FOMC used increasingly explicit forward rate guidance and asset purchases to apply downward pressure on longer-term interest rates, which were still well above zero.

The FOMC's goal in lowering longer-term interest rates was to help the U.S. economy recover from the recession and stem the disinflationary forces that emerged from it. Some have suggested that the slow pace of the economic recovery proves that our unconventional policy tools were ineffective. However, one should recognize that the recovery could have been much slower in the absence of our unconventional tools. Indeed, the evidence strongly suggests that forward rate guidance and securities purchases--by substantially lowering borrowing costs for millions of American families and businesses and making overall financial conditions more accommodative--did help spur consumption and business spending, lower the unemployment rate, and stave off disinflationary pressures." (my bold)

Here is a graphic showing what has happened to the Fed's balance sheet since 2006:

As we can see from this graphic, despite the Fed's "heroic measures" since the Great Recession began in late 2007, economic growth in the latest cycle has been rather poor compared to other cycles:

So, what lies ahead for the Federal Reserve?  Given that we are currently experiencing the third longest expansion since the end of the Second World War and that, at 103 months long, the current expansion is well above the average economic expansion length of 67 months as shown on this graphic:

...the Federal Reserve has to be considering what it will do when the economy starts to slow.  Here's what Ms. Yellen had to say about the future:

"My colleagues on the FOMC and I believe that, whenever possible, influencing short-term interest rates by targeting the federal funds rate should be our primary tool. As I have already noted, we have a long track record using this tool to pursue our statutory goals. In contrast, we have much more limited experience with using our securities holdings for that purpose.

Where does this assessment leave our unconventional policy tools? I believe their deployment should be considered again if our conventional tool reaches its limit--that is, when the federal funds rate has reached its effective lower bound and the U.S. economy still needs further monetary policy accommodation.

Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades.   Indeed, most FOMC participants now assess the longer-run value of the neutral federal funds rate as only 2-3/4 percent or so, compared with around 4-1/4 percent just a few years ago.   With a low neutral federal funds rate, there will typically be less scope for the FOMC to reduce short-term interest rates in response to an economic downturn, raising the possibility that we may need to resort again to enhanced forward rate guidance and asset purchases to provide needed accommodation...

The bottom line is that we must recognize that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound." (my bold)

It is interesting to see that Ms. Yellen admits that the Federal Reserve has "much more limited experience with using its securities holdings" to influence interest rates.  Her final statement is also quite telling.  Even though the Fed is inexperienced with quantitative easing, she clearly believes that the Federal Reserve will be forced to use unconventional monetary policies once again, even in the case of a moderate recession.  Odds are quite good that the Fed will still have a massively bloated balance sheet when it is forced to go back into the market and load up with additional Treasuries and other fixed income products and, given Japan's failure to stimulate its own economy with its even greater use of unconventional monetary policies, there is no guarantee that the Fed will meet with success the next time it needs to prod a contracting economy back to life.

Despite the fact that the Federal Reserve has no real idea about the impact of the unwinding of its $4.47 trillion inventory of Treasuries and mortgage-backed securities, it is already admitting that it will likely have to continue its experiment with quantitative easing during the next recession, even if it is a mild contraction.  As well, even though a decade and a half of QE hasn't cured the ills that plague the Japanese economy, it's full steam ahead for the Fed.

The Trump Tax Plan - Kicking the Debt Can Further Down the Road

The Trump Administration's "Unified Framework for Fixing Our Broken Tax Code" has been analyzed by the non-partisan Tax Policy Center and their findings are rather interesting in this age of a $20 trillion plus national debt.  In this posting, rather than focusing on the impact of the tax plan on individual and corporate tax levels, I will be focusing on the impact that the proposed tax changes will have on federal revenue since revenue is one of the keys to maintaining fiscal balance.

Let's start by looking at the most recent data showing the breakdown of the federal debt:

Of the $20.245 trillion in debt current to the end of September 2017, $14.199 trillion is in the form of marketable debt.

Here is a graphic showing the current debt-to-GDP ratio:

Now that we have that information, we can put the Trump tax plan and its impact on the national debt into perspective.

As we now know, the new tax framework would see the current seven individual income tax rates collapse into three rates, 12, 25 and 33 percent, depending on income level.  As well, among other things, the Trump tax plan would increase the child tax credit, repeal both the individual and corporate alternative minimum taxes, repeal the estate tax and reduce the corporate tax rate from its current 35 percent.   Owners of pass-through entities including sole proprietorships and partnerships (among others) could be elected to be taxed at a flat rate of 15 percent on their pass-through income rather than under regular income tax rates (which would be 33 percent).

Let's look at the impact on revenue.  The Tax Policy Center estimates that the Trump tax plan would reduce federal tax revenues as follows (all estimates are before accounting for macroeconomic feedback effects):

1.) Corporate Tax Revenue - by dropping the headline corporate tax rate, Washington would see its corporate tax revenue drop by $145.9 billion in 2017, rising to $289.8 billion in 2021.  Total corporate tax revenue would drop by $2.633 trillion over the period from 2016 to 2026 and by $3.231 trillion over the period from 2027 to 2036. 

2.) Individual and Payroll Tax Revenue - all proposed changes to the individual and payroll tax regime would result in Washington seeing its individual tax revenue drop by $198.3 billion in 2017, rising to $327.9 billion in 2021.  Total individual tax revenue would drop by $3.343 trillion over the period from 2016 and 2026 and by $5.385 trillion over the period from 2027 to 2036.

If we take the macroeconomic feedback effects using the Penn Wharton Budget Model into account, (i.e. the impact of tax changes on economic growth rates which range from an increase 1.0 percent in 2017 to a decrease of 0.5 percent in 2026) the total revenue losses between 2016 and 2026 will total $5.952 trillion or 2.6 percent of GDP and $10.312 trillion or 3.0 percent of GDP between 2027 and 2036.  These tax measures will have an impact on the deficit and debt as follows:

1.) Deficit - the deficit will increase by a total of $7.004 trillion between 2016 and 2026 and $15.138 trillion between 2027 and 2036.

2.) Debt - the debt will increase by a total of $22.142 trillion between 2016 and 2036.  This is a cumulative increase in the debt-to-GDP ratio of 55.5 percent over the two decade period.

Here is a table showing the full analysis with and without taking macroeconomic feedback effects into account:

Given the already high sovereign debt levels of the United States and that there is likely to be repeated economic contractions over the next two decades that have not been accounted for in this analysis and the fact that higher debt levels may result in investors demanding a higher interest rate on Treasuries, it is quite apparent that the Trump tax plan will have to be accompanied by spending cuts if Washington wishes to retain any sense of fiscal balance.  So far, the past few administrations suggest that Washington is quite reluctant to make the spending cuts necessary to  achieve even a semblance of a balanced budget, preferring to kick the "debt can" further and further down the road.  

America's Housing Affordability Issue

A recent speech by James Bullard, President and CEO of the Federal Reserve Bank of St. Louis provides us with an interesting viewpoint regarding the current state of the U.S. housing market.  In his speech given at the Bi-State Development 2017 Annual Meeting, Mr. Bullard looks at living standards across American metropolitan statistical areas (MSAs) which are defined as an area containing a large population centre and the counties adjacent to that centre, particularly those areas that have a high degree of integration with that population centre as measured by commuting patterns.  In his speech, he focuses on housing and housing affordability, a key part of living standards and a measure that may give us some sense of where the housing market is headed.    

Here is a map which shows the MSAs in the United States:

In 2015, about 86 percent of Americans lived within one of 381 U.S. MSAs and about 56 percent of Americans lived within one of 53 large MSAs which have a population of more than 1 million people.

Mr. Bullard notes that the cost of living across the 381 MSAs varies widely, driven primarily by the cost of housing.  One way to measure the cost of housing is to look at the median price per square foot as shown on this map: 

Zillow data shows that in 2015, the median home value in San Francisco was $479 per square foot compared to only $105 per square foot in St. Louis.

While raw per square foot data is interesting, an even more important measure is affordability.  Here is a map showing the share of households that can afford payments on a median-priced single-family home in their MSA:

As you can clearly see, the sun and sand states that saw their real estate markets decimated in the housing market collapse of the Great Recession are, once again, seeing their housing markets become unaffordable by a majority of their households.  This is particularly the case in coastal California where some MSAs are finding that less than one-third of their households able to afford a median-priced single-family dwelling.  There is an additional problem with the growing lack of affordable housing; households that spend a higher portion of their take-home income on housing are less able to spend on other items and since consumer spending forms a significant portion of GDP as shown here:

...we are increasingly likely to see even slower economic growth rates.

While the S&P/Case-Shiller Composite Home Price Index is showing this seemingly healthy trend:

...it's becoming increasingly apparent that, at least in some large markets, the rise in house prices in unsustainable given that housing is not affordable by a median family in that market.  This affordability problem will become even worse as interest rates begin their slow grind upwards.