How The Federal Reserve Could Rain On Trump's Tax Cut Parade

Even if the tax cuts boost growth, the central bank could slam the brakes.
LOADINGERROR LOADING

WASHINGTON ― Republicans say their tax overhaul bill will juice the economy, and most economists agree that cutting corporate taxes could boost growth, at least in the short term.

But one reason the boost won’t be as strong as Republicans might like is that the Federal Reserve would be expected to move to keep that growth in check.

Mark Zandi, chief economist with Moody’s economy.com, said that if massive tax cuts aren’t offset with correspondingly large tax increases or reductions in government spending, the Fed’s response could even cause the economy to contract.

“If the tax cuts are deficit financed, that is going to juice the economy and it will overheat, significantly raising the odds of a recession early in the next decade,” Zandi told HuffPost.

With the national unemployment rate at or beneath 5 percent for the past two years, many economists consider the economy at or approaching “full employment” ― the lowest amount of unemployment possible without spurring higher-than-ideal inflation. In other words, unemployment is low, but not so low that labor scarcity gives workers enough leverage to drive up wages so dramatically that it prompts runaway inflation.

The Fed has a dual mandate to maximize employment and keep the rate of price growth stable, pursuing the latter goal by targeting a 2 percent inflation rate. If inflation show signs of exceeding the 2 percent threshold, the Fed could hit the brakes by raising an influential interest rate. An increase in the benchmark federal funds rate ― the rate banks charge one another for overnight lending ― would dampen economic growth by raising the cost of credit throughout the economy.

Depending on how fast the Fed decides to raise the benchmark rate, the short-term benefits of the tax cuts could disappear ― or as Zandi fears, prematurely initiate an economic “bust” cycle, or downturn.

Several prominent assessments of the Republican tax cuts likewise anticipate that a counter-response from the Fed would limit the gains from them ― even if they don’t quite share Zandi’s level of concern.

The Joint Committee on Taxation, a panel that analyzes tax legislation for Congress, said in a report Thursday that the Senate version of the bill would increase growth by just 0.8 percent, an estimate roughly in line with other analyses.

“The monetary policy response function used in this analysis assumes that the Fed will act aggressively to counteract any demand stimulus resulting from the proposal because the economy is expected to be operating near full employment,” the JCT said.

In a report on the House version of the legislation, the nonpartisan Tax Policy Center also said the Fed’s response would dampen the bill’s impact.

“Interest rates are projected to rise in the short run because the legislation would boost aggregate demand and output, leading the Federal Reserve to increase interest rates to avoid a surge in inflation,” the TPC said.

Jerome Powell, President Donald Trump's nominee to become Federal Reserve chairman, testifies before the Senate Banking Committee on Nov. 28, 2017.
Jerome Powell, President Donald Trump's nominee to become Federal Reserve chairman, testifies before the Senate Banking Committee on Nov. 28, 2017.
Xinhua News Agency/Getty Images

A key point of contention is whether and how much the tax cuts sought by President Donald Trump will actually boost economic growth to such a degree that inflation will pick up enough to prompt the Fed to act.

Zandi is on one end of the spectrum, warning that the tax cuts would both significantly stimulate the economy and do so at a time when that would be unhealthy. But others are far from certain that the tax cuts will even prompt enough growth to elicit a response from the Fed.

The Republican tax cuts are due to cost $1.4 trillion over a 10-year period, according an estimate by the Joint Committee on Taxation. Absent accompanying spending cuts or tax increases, those cuts would be paid for through borrowing and add to the national debt.

The $1.4 trillion sounds like a lot of money ― and in lean times, it would probably have a greater impact.

But in today’s economy, it is a relative drop in the bucket. Even assuming the cuts are deficit-financed and every last dollar cycles back into the economy through consumer spending, the law would pour $140 billion a year into the American economy on average over 10 years ― an amount equivalent to just under three-quarters of a percentage point of the current gross domestic product of $19.5 trillion.

Many of the wealthy individuals who receive a tax cut, though, will not spend more money, so it is likely that merely half of the tax cuts will go back into the economy, said Joseph Gagnon, a former Federal Reserve economist who is now a senior fellow at the Peterson Institute for International Economics.

As a result, Trump’s tax cuts increase the chance that interest rates will rise sooner, but “not by a huge amount,” Gagnon said.

For example, the Fed’s Federal Open Market Committee, the panel responsible for adjusting interest rates, could decide to raise the federal funds rate four times between now and the end of 2018 instead of the currently expected three times, Gagnon said.

Whether the tax cuts generate so much growth that it prompts push-back from the Fed, or they merely fall short of the rosy expectations projected by GOP lawmakers, Republicans should brace themselves for disappointment, he said.

“The tax cuts are not gonna boost the economy as much as Republicans hope ― in part because I don’t believe in the long-run growth effects that some believe will occur, and in part, because the Fed may raise rates a little faster,” Gagnon said.

Andrew Levin, a former Federal Reserve economist who now teaches at Dartmouth College, was more optimistic that the economy has room to grow before inflation would become a concern for Fed officials, including chairman-designate Jerome Powell.

Even nine years after the 2008 financial crisis, inflation continues to undershoot the Fed’s 2 percent target, Levin noted. An inflation measure that filters out the more volatile prices of food and energy grew at a rate of 1.4 percent in the 12-month period ending in October, according to the Department of Commerce.

For Levin and other like-minded economists, this is evidence that the jobs market continues to hold back inflation despite the historically low official unemployment rate of 4.1 percent as of October.

The most inclusive unemployment figure, which counts workforce dropouts and people working part-time involuntarily, remains much higher at 7.9 percent.

That could be one reason why employers have been slower to give workers a raise. Wages before inflation grew just 2.3 percent in the 12 months ending in October, according to the Bureau of Labor Statistics.

The slow wage growth is one of the factors that stems inflation, since employers raise prices to compensate for the added cost of salaries, Levin said.

“If what we see over the next year is hopefully some moderate pickup in wage growth, that would be good,” Levin said. “That would give the Fed breathing room to make a few more modest hikes next year, but keep rates relatively low compared to historical norms.”

He added that Powell “has shown no signs thus far of being eager to raise rates ― and that’s probably one of the reasons he was chosen” for the Fed chairmanship by Trump.

Before You Go

Around The World With Donald Trump

Popular in the Community

Close

What's Hot