A New Policy Season in the United States
In addition to prepping my yard for the summer, my spring rituals include reflecting on changes that have occurred over the past year. As always, some things have changed, while others remain the same. My children are a year older, but for some reason they still need help with their homework when I’m mulching.
More broadly, we’ve seen another year of progress in the stabilization of the U.S. economy (https://personal.vanguard.com/pdf/ISGVEMO.pdf) and another flurry of policy discussions in the media. This time, though, the Federal Reserve has to share the stabilization spotlight with policymakers on Capitol Hill. The optimist in me believes that the policy changes being discussed reflect and can help drive a sustained expansion in the United States, but the realist in me understands how difficult that may be.
Economists view monetary policy as a reflection of economic conditions. Just as I cut my grass only when it needs it, central bankers adjust monetary policy only when economic conditions warrant it. Against the backdrop of a strengthening U.S. economy, the Fed is gradually normalizing policy, which includes raising its policy rate and, likely sometime later this year, starting to reduce the size of its balance sheet.
Just as the Fed’s purchase of assets to expand its balance sheet was a real-world experiment in monetary policy, the implications of a gradual roll-off of assets held by the Fed are largely unknown. This is why, much like the process of increasing interest rates (“It’s takeoff, not liftoff”: https://vanguardblog.com/2015/09/11/its-takeoff-not-liftoff/), balance-sheet normalization will be slow and gradual. We believe that, in order to minimize market impact, this will include three important components:
- Public communications about the plan will continue, with an announcement about the agreed-upon program coming in the late summer or early fall.
- The framework will consist of two key points: the pace of roll-off and the targeted size of the balance sheet at the end of the program.
- The Fed will initially use only one “tool” at a time and pause changes in the policy rate until the impact of balance sheet roll-off is better understood. Looking to the end of 2018, it is difficult to envision a scenario where the policy rate is 2% or greater.
If the announcement and implementation of the roll-off plan are handled in a clear, transparent, and gradual manner, there should be minimal market effect.
Change is a process, not an event
Changes are also afoot on the fiscal-policy front—changes that many people hope will push the United States back toward pre-recession rates of growth. That said, we at Vanguard believe that expecting big changes in 2017 may be overly optimistic.
Fiscal stimulus and structural changes, including infrastructure spending and tax reform, have the potential to shape our economic and financial market environment for years to come. These policies need to be vetted and implemented with care. Even if we were to see one or the other announced later this year, the economy would not realize their benefits until sometime in 2018. The most we can hope for this year would be increased confidence about the potential for policy change. While this confidence could very well push growth and inflation higher in the near term, recent softness in data and gridlock in Washington may begin chipping away at this positive sentiment.
The last 12 months have seen significant change in economic conditions, particularly in the United States. Growth is stabilizing, and inflation continues moving toward the Fed’s target of 2%. As with any economic data, rates of growth and inflation will ebb and flow, but we as investors should look past those toward bigger-picture trends.
Even if there are short-term boosts to growth or inflation this year or next, the realist in me remains concerned that the types of policies being proposed, while a step in the right direction, won’t be enough to counteract the structural headwinds we outlined in our Economic and Market Outlook (demographics, technology, and globalization).
Aside from the possibility of near-term cyclical boosts to growth and inflation, for the longer term, we would expect each to hover around 2% compared with pre-crisis average rates north of 3%. But rather than being seen as weak, such conditions should be viewed as fundamentally sound given the pressures of structural forces.
Seasons change, and so do policies, though ideally not as frequently. Investors would be well-served in the long term to focus more on their spring cleaning and fall leaf raking than in trying to construct a portfolio that fits an ever-evolving policy environment. While policy certainly can shape our economic and financial market environment, trying to predict with precision the timing, impacts, and duration of specific policies is as fruitful as when I look for help moving the 50 yards of mulch from my driveway.