Tax Reform and the Federal Reserve

One of the cornerstones of a functioning Central Bank is that it remains independent from the government, and therefore shielded from short-term political influence whilst pursuing their mandate of ensuring price stability.  While the Federal Reserve is independent of Trump’s Republicans (at least for now), they are keenly aware of the government’s actions, and factor any policy changes into their analysis, to determine the course of interest rates in order to maintain their mandate.


One piece of information that the Fed will now be considering is the potential impact on inflation from the tax reform bill being hustled through the Republican-controlled House and Senate.  The House passed the package of tax cuts affecting business, individuals, and families on Thursday of last week, moving the tax reform closer to adoption.  The Senate will be casting their votes sometime after this week’s Thanksgiving holidays.  This will be a critical time for the bill as the Republicans have a narrow majority, and can’t afford to lose more than two republican votes.


So the question is: assuming they are passed into law, how will the Fed factor the tax reforms into their inflation expectations?  White House Chief Economist Kevin Hassett, argues that the tax overhaul will boost productivity significantly, and this will result in economic growth without inflation.  “I totally respect the independence of the Fed. I would never give them advice” he said.  He worries however, that the Fed will respond to the tax cuts with a faster pace of rate hikes, which he feels would be an incorrect assessment of the impacts of the reforms.


It’s very hard to determine the impact of the tax reforms on inflation, as the reforms will take quite a some time to filter through to household wealth and therefore consumer spending, which is one of the key contributors to inflation. While there are significant tax cuts in the bill, there are also reductions in, or in some cases, complete removal of, tax deductions, so individuals will take time to understand how much more or less of their earnings they’ll be able to hold onto.  It will also take some time for corporations to determine the impact of the reforms on their financial position, and may delay any spending and investment decisions until they have clarity.  The people with their hands on the Fed lever, as well as some academics, have been expressing their views on the likely impact of the tax cuts;



What is currently expected in terms of Fed rate hikes?


As risk managers we are always seeking to inform our view on currencies from changing economic factors. In this case, if the market begins pricing in more rate hikes than are currently factored in, coupled with the fact that this is a US-specific impact, the likely impact would be a strengthening of the USD, which is in line with our overall view. 


While the Fed remains independent of the government, they are keenly aware of the Republican’s tax reforms, and will be watching the Senate vote very carefully.


Author: John Glover



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