Thoughts on the US Policy Mix

The best policy mix for a currency is an expansionary fiscal policy and less accommodative monetary policy.    It is the US policy mix of the Reagan-Volcker era of the early 1980s.  It was the German policy mix after the Berlin Wall fell.  It is as if the government has its foot on the accelerator and the central bank has its foot on the brake.  And the currency is squeezed higher.   

US monetary policy was on a path toward less accommodation before the US election, and we argued that regardless of who was elected, fiscal policy was likely to become more stimulative.   As a candidate, Trump suggested a three-prong fiscal strategy of deregulation, tax reform, and a large infrastructure initiative that was even larger than the Democrat candidates advocated.  

It seems that what has happened in recent months is that many investors have become more skeptical about the trajectory of the policy mix.  The weak growth and decline in core inflation for four months through May has prompted words of caution from some officials.  Market sentiment has swung hard from arguing the Fed is too dovish to now the consensus appears the Fed is too hawkish. 

Outside of the confirmation of a Supreme Court nominee, the Trump Administration does not have much in the way of legislative victories in the first six months in office, which is often a time that newly elected Administrations, with a majority in both chambers, have a flurry of their signature legislation.  The replacement of the Affordable Care Act has been bogged down, first in the House and now in the Senate.  The debate over healthcare is exhausting much of the oxygen from other issues.  Healthcare, as we have consistently argued is a necessary precondition for tax reform.  

There seems to be some confusion of when tax reform will be ready.  The White House legislative director was quoted recently suggested that he hoped to have a tax reform plan agreed by the Administration and both houses of Congress before the August recess in three weeks. This risks over-selling it.  A White House spokesperson expressed confidence that a plan will be agreed upon in the fall.  However, on a weekend talk show, Treasury Secretary Mnuchin said that the release of a full blown plan, as opposed to the single page memo of a couple of months ago, in early September.  He expects legislative approval before the end of the year.  

Even Mnuchin's time frame seems ambitious.  The legislative agenda is very busy and much has to be done by the end of the quarter.  Healthcare reform is still in no man's land.  Even though the Republican Party enjoys a majority, it is a slim majority, and like other modern political parties, it is a coalition.  That which appeals to the moderate wing alienates the conservative wing.    The idea of reaching out to Democrats sounds nice in practice but undermines the Republican strategy. 

Also, Congress needs to raise the debt ceiling, which has been used to get concessions that push fiscal policy in a less accommodative direction.  Then there is the spending authorization for the next fiscal year that begins on October 1.  The risk is that some temporary measures will have to be adopted to avoid a government shutdown or default.   

There are two moving parts with US monetary policy:  Rates and the balance sheet.   The Fed has hiked rates three times since last November election.  The market appears to be practically 50/50 on whether the Fed will deliver another hike this year.  There seems to be more confidence that the balance sheet adjustment can begin this year.  

Specifically, a Fed survey of bond brokers found 38% expect an announcement in September, and 33% expect an announcement in December.    We are in the former camp and expect the September FOMC meeting will announce the beginning of the process not to rollover the complete amount of maturing issues in October.  It will begin off slowly, and if we are correct, $30 bln ($18 bln Treasuries and $12 bln MBS) will not be reinvested.  It will take a year to reach the peak of $50 bln a month ($150 bln a quarter).  

The Fed's survey also found that in 2025, the median response sees the Fed's Treasury holdings amounting to $2.47 trillion, virtually unchanged from current levels.  What is envisioned is that the Overall balance sheet will shrink to around $2.8 trillion, but that the Treasury holdings will be rebuilt, while the MBS is not.  The Fed holds about $1.77 trillion mortgage-backed securities, and the survey sees the MBS portfolio falling to $600 bln by 2025.  

Some observers argue that the Fed's balance sheet must remain large enough to back the roughly $1.5 trillion of currency in circulation.  We are less convinced that currency in circulation is a floor for the central bank balance sheet.  However, we can accept that the balance sheet will not return to status quo ante or pre-crisis levels (~$800 bln).  We suspect the risk is that the balance sheet remains large and larger than expected.  

The degree of tightening represented by the shrinking of the balance sheet is much debated.  Recall that anticipation and announcement of bond purchases supported prices, but the actual operations seem to coincide with higher yields.  This is similar to what the found as well:  the announcement and signaling effect may have a greater impact than the actual buying (and holding).  This is to say that there are some reasons why interest rates are low (e.g. slow growth, low inflation, the supply of capital exceeds its effective demand).  

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