Besides prepping my yard for summer, my spring rituals include reflecting on changes 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 still need help with their homework when I’m mulching. More broadly, we’ve seen another year of progress toward the stabilization of the U.S. economy 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 could 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 as with the process of increasing interest rates, balance-sheet normalization will be slow and gradual. We believe that, to minimize market impact, this will include three important components:
- Public communications about the balance-sheet plan will continue, with an announcement about the agreed-upon program coming in late summer or early fall.
- The framework will consist of two key points: the pace of the roll-off and the targeted size of the balance sheet by 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 the balance-sheet roll-off is better understood. Looking to the end of 2018, it is difficult to envision a scenario in which the policy rate is 2% or greater.
If the announcement and implementation of the roll-off are handled in a clear, transparent, and gradual manner, the market effect should be minimal.
Change is a process, not an event
Fiscal policy changes are also afoot. Many, myself included, hope they will push the United States back toward prerecession rates of growth. That said, we at Vanguard believe it may be overly optimistic to expect big changes in 2017.
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 benefit until sometime in 2018. The most we can hope for this year would be some benefit from the increasing levels of confidence about the potential for policy change. While that could very well push growth and inflation higher in the near term, recent softness reflected in the data and gridlock in Washington may begin chipping away at this positive sentiment.
Economic conditions have changed significantly in the last 12 months, 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 investors should look past those toward bigger-picture trends.
Even if short-term boosts to growth and inflation happen this year or next, the realist in me remains concerned that the types of policies being proposed today, 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, longer term we would expect each to hover around 2%, compared with precrisis average rates north of 3%. But rather than seeing this as weak, we should view such conditions as fundamentally sound given the pressures of structural forces.
Seasons change, and so do policies, though we hope not as frequently. Investors would be well served in the long term to focus more on spring cleaning and fall leaf raking than on trying to construct a portfolio that fits an ever-evolving policy environment. While policy certainly can shape our economic and financial market environment, predicting with precision the timing, impacts, and duration of specific policies is as fruitful as looking for help moving the 50 yards of mulch in my driveway.