The ‘Trump boom’ passes its expiration date
By Lars Christensen, CEO and Founder, Markets & Money Advisory
Back in December, I wrote a weekly column for the Icelandic newspaper Frettabladid predicting that what I then called the ‘Trump boom’ would end by Easter.
By ‘Trump boom’ I didn’t mean the rally in the US stock market, but rather the improvement in macroeconomic data we started to see after Donald Trump was elected US president on November 8.
Now it is Easter – high time to see how the ‘Trump boom’ is doing.
But first, let us review what I argued back in December:
A particularly fascinating thing about economics is the importance of expectations. Consumers and investors are generally forward-looking and this means that changes in economic policy often have an impact even before they have actually been implemented.
An example of this is expectations about changes in monetary policy. Hence, it is generally expected that the Federal Reserve will increase interest rates by a quarter-point next week. This means that if we look at currency, bond and equity markets, they have already to a large extent priced the interest rate hike. This in turn means that the Federal Reserve has already effectively tightened monetary policy, which also means that the expected rate hike next week is having an impact on the US economy now.
It is really the same story with Donald Trump. He has been elected US president but will not take over before late January. This, however, does not mean that his economic policies aren’t already having an impact. In fact, the markets have already reacted rather strongly to these (expected) policies, and it seems that they expect Trumponomics to boost the US economy – at least up to a point. Hence, stock markets are up, along with US bond yields and market inflation expectations.
The fact that the markets are already reacting – most likely to the expected easing of fiscal policy in the form of tax cuts and infrastructure investment – means that we are likely to see an improvement in US macroeconomic data rather soon, probably even before Trump is inaugurated on January 21.
Paradoxically, however, this ‘boom’ could be rather short-lived. The US stock market has rallied on an expectation of tax cuts and massive infrastructure projects, which have also caused inflation expectations to increase.
The rise in inflation expectations has mostly been welcome, since they had been below the Federal Reserve’s 2% inflation target. However, as (medium-term) inflation expectations now have increased slightly above 2%, investors also realise that the Federal Reserve will respond to this by more aggressive interest rate hikes. So while Trump’s expected fiscal easing is contributing to increasing aggregate demand in the US economy, the expected tightening of monetary policy is likely to fully offset the increase in growth.
Said in another way, once it becomes clear that inflation will soon move above 2%, the fear of monetary tightening will dampen investor enthusiasm about the durability of the Trump boom. Therefore, there is ‘room’ for a near-term acceleration in US growth, as inflation expectations were below 2% when Trump was elected, but the fairly steep and swift increase in inflation expectations means that the pickup in growth might not be long-lasting.
Finally, one thing is that the Federal Reserve is very likely to try to curb the ‘Trump boom’ as it might cause inflation to rise – another thing is that Trump’s own protectionist rhetoric could do a lot of harm to the US economy.
What I described back in December was what the economic blogosphere calls the Sumner Critique, after Scott Sumner’s argument that if a central bank has a clear, well-defined and credible nominal target – for example an inflation target like the Fed – then the budget multiplier will be zero. This means that any fiscal easing would be fully offset by a tightening of monetary policy (and by market expectations that such tightening will occur).
However, the situation back in November, when Trump was elected, differed slightly from what is assumed in the Sumner Critique. The Fed’s inflation target was not fully credible, and market inflation expectations were somewhat below 2%.
That caused me to argue in several blog posts (see here and here) that the expectation of a Trumpian fiscal expansion would indeed - contrary to the Sumner Critique - have some positive near-term impact on US growth.
By December, however, medium-term market inflation expectations had already reached 2%. In consequence, the Sumner Critique kicked in and the acceleration in economic growth should have been expected to end. Which of course is exactly what happened.
If we look at a conventional ‘surprise index’ (here from Citibank) of how macroeconomic data have come out relative to the ‘consensus expectation,’ we see significant positive surprises in November, in the immediate aftermath of Trump’s election. Once market inflation expectations reached 2%, however, the ‘surprise index’ flatlined, because markets were starting to price in offsetting monetary tightening from the Fed.
This shouldn’t really be surprising for anybody who grasps the interconnection between fiscal policy announcements, monetary policy rules and market expectations. In fact, anybody who has been following Markets Monetarist bloggers (or knows about New Keynesian macroeconomic models) should understand this.
What I did not forecast (but certainly feared) in December was that the Fed would overdo it. Starting in late February, policymakers reacted to the notably improved US data by turning more hawkish. As we now know, on March 15 the Fed hiked the Fed funds target rate by 25bp – months earlier than it had been signalling. Even more significantly, it now signalled that further hikes could be expected during 2017.
The Fed’s change of stance, which really happened in late February, demonstrates another key insight from Scott Sumner – namely, that monetary policy (often) works with long and variable leads (rather than lags).
As one can see from the graph above, US market inflation expectations really started trending downwards on March 3, when Fed chair Janet Yellen clearly hinted at a March 15 rate hike. This shift took a bit longer to show up in the macroeconomic data. Even so, Citi’s ‘surprise index’ has trended sharply down since the rate hike, and President Trump significantly didn’t tweet about the March jobs report (which was surprisingly weak).
The Trump boom’s likely demise was further confirmed by Atlanta Fed’s latest Nowcast for US real Q1 GDP, which dropped to 0.5% (annualised growth). While the accuracy of Atlanta Fed’s GDPNow model is debatable, it is nonetheless remarkable that Nowcast’s sharp decline took place after Yellen’s pre-announcement of the rate hike(s) on March 3.
Therefore, it seems fair to say that the ‘Trump boom’ began to fade once inflation expectations hit the Fed’s 2% target. Yellen simply delivered the coup de grace on March 3 (15).
In the debut issue of our monthly Global Monetary Conditions Monitor (published days after the March 15 rate hike), we warned about the risk of premature and overly aggressive monetary tightening from the Fed:
Obviously, the question is whether the relaxation of global monetary conditions will continue. Here it is somewhat worrying that the Federal Reserve has now restarted its tightening cycle and that the PBoC seems to have slowed the pace of Renminbi depreciation. For now, however, it is far too early to conclude that either the Fed or the PBoC has made a policy mistake.
So are the markets already telling us that the Fed has overdone it and will have soften its stance – as it did in February 2016? Or is this just a minor blip? We will certainly investigate the matter in our next Global Monetary Conditions Monitor, due out later this month. If you have not already subscribed, make sure to do so now! See more here.
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