For Janet Yellen to actually give her “high-pressure economy” experiment a shot probably requires a Hillary Clinton victory but not a Democratic sweep.
That political outcome looks the most likely, potentially setting the stage for a rate hike in December, followed by a watchful pause as the Fed seeks to gauge just how low unemployment can go without unleashing inflation.
Yellen has advanced a line this fall that keeping rates low for longer – a “high-pressure economy” – might pay off by bringing shelved labor back into the economy and help to undo damage from the great financial crisis. This idea, which amounts to keeping the throttle open on the economy even as growth or inflation exceeds Fed targets, turns in part on hopes that productivity gains come through in response.
A Trump win, put by the FiveThirtyEight forecasting blog as a 31.6% probability, would send markets sprawling and might derail an otherwise highly likely December rate hike. Yet unfunded tax cuts and protectionism advocated by Trump would stoke growth in the near term and raise the inflation threat, giving the Fed less room for a calculated risk. That Trump would likely browbeat the Fed and threaten its independence makes it, if anything, less likely to take a “high-pressure” route.
A Democratic sweep, on the other hand, could lead to more stimulative fiscal policy that also, though warranted, should encourage the Fed to take a more conventional path back toward a “normal” interest rate, hiking in December and then two or three times next year.
A Clinton win and a divided Congress implies gridlock, or something very much like it, with not much scope for fiscal stimulus other than fiddling at the edge of the margins, such as in areas of common ground like corporate tax reform. This result, the most likely outcome, also is the most likely to encourage the Fed to hike once and then be extremely slow in subsequent increases.
Markets seem to agree: Fed funds futures are pricing in only three hikes over the next three years.
Priced in or not, if the idea is that the Fed will indeed take risks with inflation to fuel longer-term growth, the stock market should like it, a lot. An HRC relief rally, building on the one that started on Monday after the FBI said it would not recommend criminal charges against Clinton over her emails, could be sustained or extended.
Productivity questions
To be sure, Yellen has not defined exactly what she means by “high-pressure,” but the potential trade-offs are clear. Charles Evans, of the Chicago Federal Reserve, has been more forthright, saying in October that exceeding the Fed’s 2% inflation target could bring “benefits.”
Fed Vice Chair Stanley Fischer, who is a lot closer to the consensus on the Federal Open Market Committee, is also toying with the idea, to judge by a speech he gave on Friday at the International Monetary Fund. US productivity growth remains stubbornly low, raising the possibility that something, perhaps technological innovation, has changed in a way to impose a lower ceiling or typical run rate on the economy.
Acknowledging that the economy faces a problem with demand, Fischer said this further implies one of two corollaries; either productivity growth follows from growth in aggregate demand, or the reverse, that productivity growth produces its own demand.
“That is not an issue that can be answered purely by theorizing,” Fischer said. “Rather, it will be answered by the behaviour of output and inflation as we approach and perhaps to some extent exceed our employment and inflation targets.”
It is unclear if this is a threat or a promise. Is Fischer warning that the Fed might blow through its targets, or signalling that it is willing to in the cause of fighting secular stagnation?
My money would be on the latter, that the Fed is willing to see if bringing people back into the work force, even at the cost of a bit of excess inflation, will pay off as they acquire new skills and productivity, and their employers make new investments, which also may increase productivity.
Whether or not we get a chance to learn the answer may well be determined in the next 24 hours. Don’t be surprised if the market, other than the long end of the bond yield curve, decides it really likes a Clinton victory and a divided Congress.
Gridlock, plus an easy Federal Reserve, could be with us in new and innovative ways for a while yet.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
