How the Fed will respond, and how the Fed may change under Trump? - Nomura

Analysts at nomura explained that with the economy already operating close to the “maximum sustainable” level of employment, the acceleration of economic growth and inflation that we expect under President Trump’s economic policies will likely warrant an acceleration in the pace of Federal Reserve interest rate increases. 

Key Quotes:

"But other factors will affect the trajectory of monetary policy as well. First, financial conditions have already tightened. Since the election, term premia for 10- year Treasuries are up about 40bp.

 In addition the dollar has appreciated about 4% over the same period (see Figure 6). If sustained, these changes will weigh on US growth thereby limiting the pace of Federal Reserve hikes. 

Second, the FOMC’s approach to risk management may change. For the last several years Federal Reserve policymakers have weighed two competing approaches to managing the basic uncertainties that they face. One argument is that the primary risk facing the FOMC is falling “behind the curve” and having to tighten policy aggressively, risking a recession. 

To mitigate this risk, some FOMC participants argue that they should raise rates more aggressively sooner to reduce the chances of having to rapidly raise rates later. On the other hand, with interest rates still very low, the FOMC has limited tools to respond to negative shocks, but plenty of tools to respond to positive shocks. With this “asymmetry of risks” it is more prudent for the FOMC to raise rates very gradually. The election has changed the balance of these risks substantially. The expected changes in fiscal and other policies may have increased the risk that the FOMC will find itself “behind the curve.” 

But what is probably more important is the fact that we are now likely to get a fiscal response to any negative shocks. One of the foundations of the “asymmetric risks” argument was that the Fed was the “only game in town.” That is, before the election, with “gridlock” in Washington and the Republican-led Congress.