Following months of anticipation, the FOMC finally announced the initiation of its balance sheet reduction plan on September 20, and as many expected, the market reaction was muted. Fed leaders did a good job of telegraphing the move in the prior months, and the pace of reinvestment tapering will begin at relatively small levels before ramping up over the next four quarters. As such, agency MBS spreads actually tightened modestly immediately following the announcement. While the balance sheet announcement was somewhat anticlimactic, there were some noteworthy items in the Fed quarterly release of the Summary of Economic Projections (SEP). FOMC participants reaffirmed their expectations for one more hike in 2017 and three in 2018, but the 2019 and long-run projections for the fed funds rate were lowered modestly (20 bps).
The unchanged projections for 2017 and 2018 boosted market pricing for a December rate hike, but there is still some uncertainty as to how a potential change in Fed leadership will impact monetary policy in the coming years. Fed Chair Janet Yellen’s term expires at the end of January 2018, and there are currently four open seats on the Board of Governors to fill (out of seven). This includes Vice Chair Stanley Fischer, who abruptly resigned in September, and White House nominee Randall Quarles has yet to be confirmed by the Senate. Quarles was nominated to be the Vice Chair of Supervision, which oversees the Fed’s bank regulatory efforts. This means that the Fed is understaffed at a very busy time for the central bank (i.e., ongoing policy normalization). The three vacancies prior to Fischer’s resignation were actually inherited by the Trump administration, to which the President has a somewhat rare opportunity to appoint five of the seven seats on the Fed board (the term of a board member is 14 years).
Trump hasn’t completely dismissed the idea of asking Yellen to serve another 4-year term as Chair, but the general expectation is that leadership will change. If so, how will future policy be affected? Last Friday, President Trump met with both current Fed Governor Jerome Powell and former Governor Kevin Warsh, presumably to discuss the Fed Chair position. Recent press reports suggested that the White House could reach a decision on a Chair nomination in 2-3 weeks.
In recent months, it’s become clearer that the Fed appears more intentional in differentiating the decision making framework between interest-rate policy and financial stability efforts; the latter is tied closer to balance-sheet reduction. Most expect the Fed to continue with this plan even if inflation growth falters. Whether or not the Fed continues to shrink the balance sheet amid a recession is less known at this point, but interest-rate policy should be tied closer to the inflation and overall growth trend.
Tax Reform Plan
On September 27, the so-called “Big 6”, comprised of Congressional Republicans and White House officials, released the GOP’s “Unified Framework for Fixing Our Broken Tax Code.” The markets have been eagerly anticipating the Republican’s initial tax reform plan for much of 2017, and while this announcement was delayed due to various factors (healthcare reform, budget debate, etc.), this is a necessary first step to getting legislation drafted and passed. The highlights of the proposal include a reduction in the corporate tax rate (35% to 20%), partial expensing of capital investments, and a simplification of individual tax brackets. There would also be a one-time repatriation tax at a lower rate to incentivize multinational corporations to bring profits back to the U.S. from overseas subsidiaries, and some tax deductions would be eliminated, such as state and local tax payments. For individuals, the number of tax brackets would be cut from 7 to 3 (12%, 25%, and 35%), with the option to add a fourth bracket above 35%.
While official scoring of the plan by the Congressional Budget Office (CBO) has yet to be released, early estimates from Citigroup analysts suggest the plan would reduce tax revenues by at least $2 trillion over 10 years, and by their same estimates, the plan might add a cumulative 2.9 percentage points to GDP growth over the first few years, holding all else equal. Regarding the growth implications, the words “might” and “all else equal” are important disclaimers. Such forecasts rely upon many assumptions, and more importantly, no one knows what the final legislation will look like, assuming a tax reform bill gets passed at all. This will be a very contentious battle, even within the GOP itself. Senator Bob Corker (R-TN) was quoted on September 27 saying “tax reform is going to make health care look like a piece of cake, if we do it the right way.” Some suggested in recent months that tax reform might be less controversial than the health care effort, but we are all learning that any significant legislative effort is extremely challenging in the current environment. At the same time, there’s a reason why momentous tax and health care reform is a rare event.
GOP fiscal hawks in the House and Senate will likely have issues with a lack of spending offsets to the revenue cuts, and within days of the announcement, there has already been intense scrutiny of the proposed elimination of the state and local tax deduction. Further, the optional fourth tax bracket for the highest income earners was likely meant to be a compromise for those strongly opposed to tax cuts for the “super rich,” but House leadership has been adamant that they are committed to tax relief for all. Opinions vary on the timing of this legislative venture. Some analysts suggested a Q1 2018 timeframe, but this could very easily drag on for six months or more.
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