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Trump and tax cuts - Fed and rate rises

Posted by: Brian Dennehy
Membership level: Free
Much has been made of the tax cuts announced in the US, not least by Donald Trump.  While the cuts are real, the trumpeted benefits will likely turn out to be more fake news.  Meantime interest rates are heading up - why?  
It is assumed that extra profits derived from tax cuts will motivate businesses to spend more on investments, increase staff numbers, or raise salaries – all of which would release these tax savings into the economy.  But the evidence of recent years is that companies will not do that.  
For example, rather than wage increases, we will likely see more share buy-backs.  This increases earnings per share, a key measure of the bonus structure of many CEOs, thereby boosting the earnings of “The 1%” – more financial engineering.
In the short term the cuts might be sufficient to boost confidence a bit more, and push the US market a tad higher. But this is probably just hot air blowing the bubble a bit higher.
Inflation: myth and mystery
Interest rate rises are being led by the US, with the UK following (though very tentatively).  The widely reported excuse for higher rates is rising inflation or the risk of rising inflation.
In particular the risk of inflation arises, we are told, because when the unemployment rate gets down to a certain level, labour scarcity will force wages higher – this is called the Phillips Curve.  But it is bunkum.  
Sometimes this happens, sometimes it doesn’t – it is simply not a statistically significant relationship. Despite this the staff at the Federal Reserve apparently continue to be guided by it, instead of looking for a better model.  
Reliance on the Phillips Curve is one of the reasons why the Fed (and central banks generally, and the World Bank, and the OECD) make persistent prediction errors and, more importantly, policy errors.  
Higher interest rates: why?
The Federal Reserve Chair Janet Yellen even went as far to say continued low inflation was a “mystery”.  That is a real worry when you consider that controlling inflation is one of their only two mandates – and they don’t understand one of them!  
What the Fed is probably more worried about, but won’t shout about it, is that they have created another bubble environment - not just one but several (stock market and bonds, plus bitcoin), the busting of which will undoubtedly create financial and wider economic instability – remember 2008.  In addition the economic expansion since 2009 is long in the tooth, and before the next recession or financial crisis comes home to roost, the Fed wants interest rates at a higher level from which cuts will have an impact.
Whatever the case, rates will only go up gradually, as the Fed fears creating the bust by its own actions - although there is no precedent for an investment bubble deflating gradually, so do bear this in mind.
The UK is similar in some respects, with the added uncertainty of Brexit, and a weak pound triggering higher inflation (albeit that it is temporary and washes through).  The Bank of England understands that UK is on a tightrope.  Many companies that should have gone bust a decade ago have stayed afloat by taking on cheap debt – and consumers have maintained a level of consumption (whether furniture, cars or houses) which is unsustainable with higher rates.
Don’t worry about inflation. But do have a weather eye on the impact of higher interest rates.
Topic: Market commentary


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