The Policy View From Washington

Lawmakers put the finishing touches on the budget bill, which will remove most of the fiscal policy uncertainty for the next two years. That’s helpful for the economy and the financial markets, although the debt ceiling remains a possible trouble spot. Federal Reserve officials seem intent on continuing the tapering of asset purchases, but economic and financial market developments will dictate the pace.

The budget agreement reached last month, and ironed out in the last few weeks, is a huge deal. Granted, it says a lot that Congress can receive accolades for simply doing its job (and three months into the fiscal year at that), but we haven’t had a real federal budget since the early months of the Obama administration. Spending has been authorized through a long series of continuing resolutions. This budget agreement removes policy uncertainty for both this year and next.

The budget agreement left one important element unsettled. The debt ceiling was waved until February 7. After that, the debt ceiling will be whatever the federal debt is at that point. That doesn’t mean that the government won’t be able to borrow. The Treasury can take evasive action (borrowing from certain government retirement funds, etc.) to allow the government to borrow for weeks, and if it can make it past April, the big month for tax revenues, Treasury might be able to borrow for months. However, the debt ceiling will have to be raised at some point. The debt ceiling has never made sense. Congress sets taxes and spending, which determine the budget deficit (and cumulatively, the federal debt). Yet, there is precedent here. The party out of power has always used the debt ceiling as a bargaining chip. Republicans want to get something out of the next increase in the debt ceiling. At this point, they just don’t know what that is. Still, most expect that any showdown over the debt ceiling won’t turn into a crisis.

The budget deal is seen as a failure for the Tea Party, which opposed the agreement. The Tea Party received a lot of the blame for the shutdown fiasco in October. More moderate Republicans believe that the party “bit off more than we could chew,” but still blame President Obama and Senate Democrats for taking a hard stand and not negotiating.

So, is this a new era of bipartisanship? Not likely. The two parties will have a few months to work together, but are unlikely to achieve much. Moreover, this is an election year. Nothing is expected to get done after March or April.

While populism on the right (the Tea Party) appears to have faded, the Democrats are likely to try to fan populism on the left. Income inequality is expected to be a growing issue in 2014 and that could be a key factor in the November elections.

Still, the Democrats will face an uphill battle in trying to regain control of the House. Democrats, with more seats to defend this year, will also be playing defense in the Senate.

Meanwhile, incoming Fed Chair Janet Yellen will face a number of challenges as the central bank gradually normalizes monetary policy. Recent economic data have been mixed. The job market is still a long way from normal, but we have seen good progress over the last year. The Fed has downplayed the 6.5% unemployment rate threshold (a “guidepost,” not a “goal”) for the federal funds target rate. That 6.5% threshold is likely to be hit in a few months. The Fed will then look to a wide range of labor market indicators as it sets the pace of tapering. Hiring and quit rates, two indicators emphasized by Janet Yellen, are still low. Minutes of the December policy meeting emphasized that there is no set path for tapering, but most Fed officials expect that the asset purchase program will be completed by the end of the year. That works out to about a $10 billion reduction in the pace of asset purchases at each policy meeting.

At this point, a gradual taper is widely anticipated by the markets. For the Fed, it’s not so much a question of whether to taper further, but whether the economic outlook and financial market developments will be sufficient enough to argue for a faster or slower rate of tapering. The continued high level of slack in the labor market and the low trend in inflation are concerns, but economic growth is widely expected to pick up in 2014. Most Fed officials feel that asset purchases are less effective and potentially more risky the longer they go on.

The Fed may have a tough time in managing market expectations of monetary policy. The markets now seem to have recognized the Fed’s emphasis on forward guidance (the conditional commitment to keep short-term interest rates low). However, the economic data may be choppy, especially during the winter months, leading to shifting market expectations of when the Fed might begin raising short-term rates. While long-term interest rates are expected to trend gradually higher as the economy recovers, we could see some volatility in bond yields.

The pace of tapering is likely to remain a concern for the emerging economies, which are susceptible to capital outflows. However, while the Fed pays attention to possible adverse reactions abroad, such concerns aren’t going to prevent the Fed from acting. Monetary policy is based on the domestic outlook.

The Fed chair’s annual monetary policy testimony is expected to be scheduled for early March. Worries that the Fed policy would lead to sharply higher inflation were, in hindsight, unfounded. However, some politicians remain concerned that the seeds have been sown for a possible “problem” in the bond market down the road. Yellen should put those fears to rest.

© Raymond James

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