The Trump Administration and Republicans in Congress are trying to enact tax cuts, heavily geared toward large corporates in order to boost growth in the US. Without getting into the likely effectiveness of the proposals, I want to look at what impact these cuts could have on monetary policy given the flattening of the yield curve in the US. My view is that tax cuts would accelerate the Fed's timetable and increase the potential of curve inversion and eventual recession.
Right now, we are into our ninth year of recovery, with core inflation rising toward the Fed's 2% target. In theory, the Fed's rate policy is ‘symmetric', meaning that it doesn't see 2% as a ceiling that informs rate policy action, but as a longer-term target. Nevertheless, the Fed has said that, given that the headline unemployment rate is close to 4%, it needs to stand ready to pre-empt a rise in inflation because it believes lower unemployment will produce unwanted inflation. Basically the headline unemployment rate trumps the inflation rate. And this is why the Fed has begun to raise rates even though inflation remains below target.
The Fed has said that it is prepared to raise rates 4 more times by the end of 2018, if the economy performs as it expects. But then, what happens if we get a big tax cut without an offsetting cut in expenditures? I believe we would get a monetary offset – meaning that the Fed — already on notice because of its belief that we are at full employment — would look to counteract that stimulus, for fear that it would cause the economy to overheat, creating unwanted inflation. Perhaps we would see 5 or 6 hikes by the end of 2018 in that scenario.
Given how flat the yield curve is right now, it's not inconceivable that a rate hike campaign this aggressive could flatten the yield curve even further and eventually invert the curve, presaging an abrupt economic slowdown. Now, I don't believe the Fed would actively invert the yield curve, raising rates until the yield curve inverts. Instead, we could see a rate hike campaign that caused 2-year Treasury yields to rise more than 10-year yields and put the curve in the 30-50 basis point region. If this is followed by a decelerating economy, the Fed would then stop cutting. But the economy could then decelerate so much that the yield curve inverts for a few months, usually a reliable signal of recession.
