As the Trump Administration settles in to the Oval Office in late January, one of its foremost objectives should be to provide clarity on its policies, according to Patrick Harker, president and CEO of the Federal Reserve Bank of Philadelphia who was formerly dean of Wharton and president of the University of Delaware.
“My biggest concern is concern,” said Harker. “The biggest risk we face is uncertainty. If you ask every business leader, their biggest concern is: ‘Whatever changes occur, just do them gradually. Let us adapt.’ They have been in a world of change for a long time. That’s not going to go away; we can’t take away change…. Their biggest concern is if something hits them, and they simply can’t or don’t have the time and the resources to adjust.”
Harker and Wharton finance professor Jeremy Siegel discussed the outlook for the U.S. economy in 2017 on the “Behind the Markets” show on Wharton Business Radio on SiriusXM channel 111. Siegel hosts the show with Jeremy Schwartz, director of research at WisdomTree. (Listen to the podcast at the top of this page.)
Harker seemed to echo the sentiments at the Federal Reserve, as recorded in the minutes of the Federal Reserve’s Federal Open Market Committee meeting on December 13-14 that were released on Wednesday. “[The FOMC members] pointed to a number of risks that, if realized, might call for a different path of policy than they currently expected,” the minutes noted. “Moreover, uncertainty regarding fiscal and other economic policies had increased. Participants agreed that it was too early to know what changes in these policies would be implemented and how such changes might alter the economic outlook…. Moreover, many participants emphasized that the greater uncertainty about these policies made it more challenging to communicate to the public about the likely path of the federal funds rate.”
Siegel said Trump’s victory “has changed everything for the Fed as well as for the economy.” He agreed that many basic policies of the Republican Party, many of which Trump supports, “are very positive for the market.” He noted that while the financial markets were prepared for a Hillary Clinton victory, they adjusted quickly to the reality of Trump as president and rallied ahead. “I thought it would take them a little longer to get from the negatives to the positives,” he said. “It took about six hours before they said, ‘Wow, this could be very, very good.’” Stock prices and bond yields showed “a tremendous rise.”
“My biggest concern is concern. The biggest risk we face is uncertainty.” –Patrick Harker
Siegel added that the financial markets were relieved that following his victory, Trump took a softer line on issues such as U.S. relations with China and Mexico than he did during the campaign. “The first thing he didn’t say was he was building the wall [on the border with Mexico] and cutting off trade with China, which of course scares the market, as it should…. He has been much more conciliatory on those, and he appointed people who are globalists and understand the importance of trade.” It also helped that Trump seemed to embrace the Republican Party agenda and was willing to meet with Paul Ryan, speaker of the House of Representatives, who had reluctantly endorsed Trump.
According to Harker, part of the market reaction was simply about resolving the uncertainty around the election period, clarifying that he was speaking in his personal capacity and that his remarks do not reflect those of the Federal Reserve or the FOMC. “I hear from the market that people are optimistic, but until the specific policies come in play that we can model and analyze, it’s hard to say if the market has over or under reacted, or whether it is going to boost or not boost economic growth.”
Harker pointed to the so-called Partisan Conflict Index that the Federal Reserve Bank of Philadelphia publishes, which monitors “the degree of political disagreement among U.S. politicians at the federal level” as it is reflected in media reporting. “When [partisan conflict] is heightened, it hurts economic development and economic growth,” he said. “Any uncertainty is bad for the markets.” He noted that the index stayed elevated all the way through the election. However, he predicted that the index would decrease after post-election data is factored in.
According to Siegel, the prospect of lower corporate taxes in the Trump regime was a big factor in the 6%-8% rise in the S&P index. “We don’t know if it will be effective in 2017 or 2018, but analysts expect a 10% increase in corporate earnings as a result of lower taxes,” he said. “That in and of itself can explain a 10% rise in markets.” The second factor that explains the surge in the index is the hope for fewer regulations, he noted. Also at work are expectations that the Affordable Care Act will be repealed, as well as a loosening of regulations on the financial sector. Another factor is the expectation of infrastructure spending, pushing up some stocks and commodities related to that, he added.
Corporate tax reform “is important for the U.S. to be globally competitive,” Harker said. The possibility of U.S. firms being asked to repatriate taxes will have a positive impact, he added. (During his campaign, Trump said he planned a one-time tax holiday of a 10% tax instead of the existing 35% to lure U.S. companies to repatriate money held abroad.) It remains an open question as to what will replace the revenue lost as a result of that tax holiday. “Another open question is how the total corporate tax package – not just corporate taxes – gets resolved over time.”
“Positive momentum” exists on how people feel about reduced regulations, Harker said, but he added that much depends on how that plays out over time. The Republican Party has announced several proposals, but they are yet to be finalized. “What do those packages look like, when it is all said and done — that is the key for me. Right now, it is too early to tell.”
Siegel pointed to the prospect of changes to the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act that was enacted after the financial crisis. “There are some good things and some bad things in Dodd-Frank,” he said. “Could we selectively undo parts of that act and spur the banking system again?” Harker agreed that “there are some good parts about Dodd-Frank that we need to maintain.” He offered the example of the provisions in that statute for the resolution process for failing banks. “Whether it is Dodd-Frank or in other venues, we need to have a very clear path when a bank gets into trouble – how do we quickly resolve that issue, and not let it linger for too long,” he said. “When it lingers for too long – as we saw in the 2007-2008 financial crisis – the contagion effects are quite severe.”
The regulatory regime for well-performing banks is also getting easier than before, said Harker. He gave the example of the Federal Reserve Bank of Philadelphia. It oversees the Third District (covering eastern Pennsylvania, southern New Jersey and Delaware), which he described as predominantly one with community banks. “In any crisis, the pendulum swings one way, and then it starts to correct the other way,” he said. “We’re already seeing it. The period between examinations is getting longer for community banks that are in good standing; we don’t have to do it every year; we can do it every 18 months. We can start to relieve some of the regulatory burden for them.”
Harker said the Fed by itself can do little to dismantle regulations in a way that can bring about more certainty in the markets, in response to a question from Siegel. “It’s up to Congress,” he said. “But I do know we don’t want to create these unintended consequences, removing everything, when there are things that we know are working well, or other things that just need enough time to see if they work well or not.”
“The Fed is fierce about its independence and bristles at being told how to conduct monetary policy.” –Jeremy Siegel
Keeping an eye on global banking systems is another Fed objective. The Basel Committee on Banking Supervision said on Tuesday that it has postponed a meeting to discuss tighter capital adequacy standards from January 8 to March 1 after European Union officials opposed some of the proposals. Harker said the Fed is monitoring that situation, especially as it relates to Italy. He added that for now, it did not see any significant contagion effect from that on the U.S. financial system.
Border Adjustable Tax
Siegel noted that some Republicans in the House of Representatives are proposing “radical” legislation on the so-called “border adjustable tax.” That plan calls for a 20% tax on imports and a special tax exemption for income from exports. That would be “devastating” for companies such as Wal-Mart, he said. Harker expressed his inability to comment specifically on that. “In this globally interconnected world, where you have these globally interconnected supply chains, anything that would happen would be disruptive,” he said. “The question is, is that disruption worth it?”
Harker said recent data showed that about 40% of the value-add on the goods the U.S. imports from Mexico is actually produced in the U.S. “So highly engineered products produced in the U.S. go across the border [to Mexico] and then come back,” he said. “That is happening across the globe, so we have to disintegrate these integrated supply chains to get an answer. It’s not as though we are simply importing something that is produced solely in China or solely in Mexico. These parts are going back and forth. That’s what gives me pause about having an opinion on this until you disentangle those supply chains.”
Growth and Unemployment
According to Harker, “The Fed monetary policy is an extremely blunt instrument. We have one tool, essentially, [which is] the Fed funds rate…. We don’t create economic growth. Good monetary policy creates the conditions for economic growth to occur. It doesn’t stifle it. Economic growth happens by real companies and real communities with real people working there. We need to focus on those policies and us facilitating and having people understand [what we do].”
According to Siegel, the Fed has faced unfair criticism questioning its role in fostering growth. “The Fed is not responsible for the fact that we’ve had a measly 2% a year growth. In the long run, it is productivity [that matters],” he said, noting that along with a big slowdown in population growth, productivity has fallen. He wondered if that might be due to over-regulation or a downturn in innovation.
Siegel noted that notwithstanding Trump’s proposals, and the jump in stocks and in bond yields, the real GDP growth in 2017 over 2018 is projected “at a measly one-tenth percent.” That could be interpreted in three ways, he said. One is that expectations are low on what Trump could do. Two, much depends on working through Trump’s policies when there is more clarity on them. Three, maybe long-run growth isn’t much more than that. “If [Trump] pushes [to get economic growth], we’re going to have to [increase] interest rates to keep the labor market in line and stop inflation,” he said.
Harker said that in his view, the growth rate in U.S. GDP in 2017 would be 2.3%, settling back to 2.1% in 2018 and 2019. Those projections do not factor in any economic stimulus that the Trump Administration and the new Congress may inject, he added. Without any additional stimulus, he projected a dip below the natural rate of unemployment. “Barring some change in productivity, we would see some inflationary pressures, and we are starting to see some of that right now, anecdotally,” Harker noted.
“It would be very difficult to tie the hands of the committee to say one must follow one particular rule, because there could even be an argument over which rule [to follow].” –Patrick Harker
Regarding the labor force, Harker said one threshold for action would be when the unemployment rate dips significantly below a natural rate to 4.7% or 4.8%. The natural rate is the long run rate at which there won’t be any particular inflationary pressures that arise, Siegel explained. The unemployment rate declined by 0.3 percentage points to 4.6% in November 2016, based on data released by the Bureau of Labor Statistics (BLS) on December 2. The unemployment rate for December was “little changed” at 4.7%, the BLS said when it released its latest data today (January 6). The Fed expects the unemployment rate to dip in 2018 and 2019 to 4.5%, but Harker said his estimate is 4.4%. “We need to be adaptive to the policy framework outside of monetary policy,” Harker noted. “As those things change, we have to change our forecast and our path.”
Funds Rate Outlook
Siegel asked Harker about the “steepness” he wants in raising interest rates, or the frequency of it between Fed meetings. The “dot plot” for 2017 suggests closer to three rate increases, while last year saw only one increase, Siegel noted. The Federal Reserve’s so-called “dot plot” published after every meeting reveals the funds rate projected by the members of the Federal Open Market Committee. In its last meeting on December 12, the Federal Reserve increased its benchmark federal funds rate by 25 basis points from 0.50% to 0.75% in a unanimous vote.
“I’m in for three [rate] increases [in 2017],” Harker said. “However, that’s subject to a lot of uncertainty. As the policy uncertainty resolves itself, we’ll be able to see whether it is three, two or four. Right now, given where the economy is, and at least our best estimate of the growth path we are on, I think three [increases] is appropriate.” However, that is subject to revision, he added.
Siegel noted that policy watchers are now pegging inflation at 0%, which may have to do with “slower long-term growth and maybe slower long-term productivity growth.” Harker said he does consider those factors in his push for a steeper normalization path for interest rates. “It fundamentally comes down to one thing – how do we raise economic growth in the country?” he said. “Economic growth is productivity growth plus growth of the labor force. Neither of those issues is in the [control] of the Federal Reserve System. We are there to support that growth through monetary policy, but these are policies that are outside [our control]. It’s in states, in communities and cities, it’s [about] moving productivity and bringing highly skilled people into the workforce, coming from inside the U.S. and actually outside the U.S.”
One looming controversy is the Republican call for the Federal Reserve to follow the so-called Taylor Rule for setting interest rates or at least benchmarking them. Conceived by John Taylor, academic and monetary theorist and former undersecretary of the Treasury, the rule sets a strict mathematical relationship between inflation, output and the Fed Funds Rate, apart from whatever else might be happening in the economy. “The Republican Party has proposed legislation that the Fed should look at that and report to Congress when they deviate from that,” said Siegel. “The Fed is fierce about its independence and bristles at being told how to conduct monetary policy.”
“We need to stimulate new business formation and we need to stimulate new workers with the skills necessary for that productivity to occur.” –Patrick Harker
“At every meeting, and in preparation for every meeting, we look at all these rules,” Harker said. “There’s no one rule. There’s a Taylor Rule, the optimal control rule, etc. We look at those carefully to see what they say about the appropriate path or policy of the Fed funds rate. That said, to dictate policy by one rule – first, you have to pick the rule. You may just have the wrong model. Next, you are putting data into the model that you know gets revised over time – that’s imperfect.”
Harker said models that supposedly guide interest rate decisions incorporate “data that has a lot of noise around it – GDP, inflation, unemployment numbers, etc.,” which of course keep changing. “So now you have model risk and now you have uncertainty around the data,” he said, arguing that such methods may not produce the appropriate policy path. “As a modeler, in my career as a quant, I find that difficult to accept. I think we need to look at those rules and take those rules seriously. But it would be very difficult to tie the hands of the committee to say one must follow one particular rule, because there could even be an argument over which rule [to follow].”
Siegel raised the question of whether the U.S. could escape its productivity slump. “It could — never say never,” said Harker. “I’m an optimist and I do believe in the creativity of American businesses and of American business leaders.”
With the proper support from policy, increased productivity could occur, Harker noted. Productivity has dropped for several reasons, he said, including the shift from high-productivity manufacturing to services. “We are consuming more and more services as we age – that is a secular trend and is not going away.”
Harker also listed other factors for declining productivity such as the impact of “aging firms and aging workers” and the slowdown in new business formation. “New businesses tend to have higher productivity,” he explained. “We need to stimulate new business formation and we need to stimulate new workers with the skills necessary for that productivity to occur.” Some “difficult” issues that have to be tackled include immigration, especially as it relates to the demand for high-tech workers, he added. The U.S. also needs to create a more competitive environment “so that we have [a] turnover of firms.” As more productive firms enter the market, there would be winners and losers, and “we need to make sure that occurs.”