November 16, 2018 / 12:01 PM / 8 months ago

REUTERS SUMMIT-RPT-The economic sugar rush and the Fed: a rate hike quandary

 (For other news from the Reuters Global Investment 2019 Outlook
Summit, click: here)
    By Jonathan Stempel and Jennifer Ablan
    NEW YORK, Nov 16 (Reuters) - The sugar rush that President
Donald Trump's tax cuts and fiscal stimulus injected into the
U.S. economy poses a quandary for the Federal Reserve and its
chairman, Jerome Powell, in their campaign to raise interest
rates: where and when to stop?
    Investors and economists at this week's Reuters Global
Investment 2019 Outlook Summit agree that more rate hikes are
    But they said overtightening could backfire as the economic
benefits from Trump's policies wear thin, perhaps exacerbating
the surging market volatility that reared its head in October.
    Given the Fed's "dual mandate" of price stability and full
employment, "it would be very hard for them to justify pausing
when by almost any measure, interest rates are still below
neutral," said Scott Minerd, global chief investment officer at
Guggenheim Partners in New York, which invests $265 billion.
    "The question is: Where is the neutral rate?" he said.
    In December 2015, the Fed ended seven years of near-zero
interest rates that followed the financial crisis, gradually
pushing its benchmark federal funds rate to the current 2 to
2.25 percent.
    Some of that increase has coincided with the Fed's campaign
to start shrinking its balance sheet, which quintupled in size
after the crisis.
    "The Fed is doing the right thing," said Byron Wien, vice
chairman at Blackstone Private Wealth Solutions Group. "The Fed
did the wrong thing by keeping rates low for too long."
    Summit speakers expect another 0.25 percentage point rate
hike when the Fed meets in December, and one to three additional
hikes in 2019.
    But they worry that the Fed's focus on known economic and
market data could leave it behind the curve when economic growth
starts to meaningfully, and inevitably, slow or end.
    "I don't think they're doing anything wrong, but that
doesn't mean they're not at risk of making a policy mistake,"
said Joachim Fels, global economic adviser at Pacific Investment
Management Co in Newport Beach, California. "The biggest risk is
the Fed moving too fast. ... Nobody really knows where that
neutral rate of interest is."
    Fels' firm invests $1.72 trillion. He expects a rate hike in
December and two more in 2019.
    The Fed likely can afford to act gradually.
    With U.S. unemployment at a 49-year low and the economy
expanding at a 3.5 percent annual rate, investors and economists
are not expecting a slowdown or downturn before 2020.
    But they worry that neither the Fed nor lawmakers might have
the tools to fight the inevitable, with Trump's trade policies a
key potential downside risk and the federal budget deficit
expected to balloon.
    The deficit was $779 billion in the recently completed 2018
fiscal year, up from $438 billion three years earlier, according
to the Congressional Budget Office here/54647-MBR.pdf.
    "If you look at all past cycles, has the Fed ever been able
to accomplish a soft landing? I don't think that's true," said
Monica Erickson, a bond manager who helps invest more than $120
billion at DoubleLine Capital LP in Los Angeles.
    "Real rates are still very low, so you really need to bring
them up, but if you bring them up there is a risk of cutting off
the party," she added.
    Minerd expressed concern the Fed might be too slow to
recognize when its policies might be inducing a recession,
reaching the height of its tightening just as "fiscal drag"
begins creeping into the economy, which he expects in 2020.
    Not that recession is always a bad thing.
    Recessions are "natural and necessary in a capitalist
system," Minerd said. "By flushing out excesses you avoid
malinvestment, allowing inflation to become entrenched, and
other policy errors, and then it gives you a foundation to build
a new expansion."
    Powell has sometimes rattled markets with hawkish language.
    On Wednesday, Powell said the economy looked "really
strong," but he cited caution over the longer-term trend due to
slowing growth abroad and because the boost from the tax cuts
and spending increases will "wear off over time."             
    The Fed chairman has drawn frequent criticism from Trump,
who fears that high rates could harm the economy.
    Powell "will gradually tone down the language, but it will
be in response to the economy and to the data, not in response
to Trump," said Fels.
    "Some more tightening in financial conditions is quite
welcome. If markets kept going up in a one-way street, then that
would raise the risk of a much bigger correction later on."
    A few summit speakers encouraged Trump to tamp down his own
rhetoric toward the Fed.
    "For him to criticize the Fed is wrong," said Wien. "At this
stage of the cycle, the federal funds rate should be something
like 4 percent. ... What better time to normalize rates then
when the economy is humming? And the economy is humming."  

 (Reporting by Jennifer Ablan and Jonathan Stempel in New York
Editing by Leslie Adler)
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