Limited room for Fed easing

However, we should also recognise that many of these policies will sap growth. Given the Fed’s dual mandate, more limited policy easing may not be the gimmie that the market seems to think.

Since Trump’s election victory started to look more likely back in October, we’ve seen the fed funds futures market take out about 100-bps of assumed Fed easing through to the end of next year. The market now thinks that the base of the easing cycle will be closer to 4% than 3%. In some ways, this adjustment seems understandable. Policies such as punitive tariffs, tax cuts and mass deportations are all thought to stoke inflation—and hence a response from the Fed. But these same policies are growth-sapping as well and the market might not be focusing enough on this fact.

If we take the topic of tax cuts, for instance, the main plank of Trump’s plan is to make his temporary 2017 personal tax cuts permanent when they expire at the end of 2025. The Committee for a Responsible Federal Budget put the cost of this at over USD5tr through the next decade. But these are not tax cuts as far as the consumer is concerned; instead, the policy just means that tax hikes will be avoided.

The consumer will not see his or her disposable income rise as a result of this tax cut [sic], and, as a result, their spending is unlikely to increase (and so create inflation). Of course, it is possible that very responsible and farsighted consumers have planned for the end of the tax cut in late 2025 and have been'saving up’ to prepare for it. Such savings could be released should the tax cut become permanent, and so stoked demand. But do consumers behave like this?

Steve Barrow, Head of Standard Bank G10 Strategy, very much doubts it. Of course there are other tax cuts that attract headlines, like a cut in corporate taxes, but this is seemingly only for manufacturers that produce in the US and the revenue cost of this over the next decade is put at just USD200bn. In short, it won’t move the dial when it comes to growth or inflation.

What about tariffs? These are seen as lifting inflation, but we have to bear in mind that tariffs are as much a supply shock and negative supply shocks lower growth just as much as they lift inflation, especially if other countries retaliate, as seems very likely. In addition to this, we need to be aware that the negative impact on growth outside the US will likely blow back and weigh on the US as well.

Right now, the momentum in the US economy is clearly towards falling inflation and rising unemployment, which is why the Fed has been easing policy. Steve Barrow suspected that tariffs would be likely to have more traction in promulgating the rising trend in the unemployment rate than turning around the decline in inflation. Why does he say that? One key reason is that these trends produce behavioural changes. For instance, firms that have already started to reduce hiring or layoff workers may feel more disposed to carry on these trends under tariffs, than consumers will be prepared to put up with a reversal in the moderation of inflation that they have seen in recent years. In short, tariffs are more likely to go with the flow than be able to push against it.

“We could go on but we think the point has been made that the Fed’s dual mandate of 2% inflation and full employment means that its response to Trump’s policies are not as clear-cut as the market might be pricing in right now. In short, the Fed could just as easily maintain, or even increase the speed of easing because of the harmful effects on growth and employment, as it could clam up on rate cuts because it fears higher inflation. With this in mind, we still see steady rate cuts through the first half of next year with the Fed more likely to take rates below 4% than keep them at, or above, this level,” said Steve Barrow.