December 12, 2016 / 6:04 AM / a year ago

Fed turns to Trump agenda with rate hike nearly in the bag

WASHINGTON (Reuters) - The Federal Reserve inaugurates the Trump era this week with a near-certain interest rate increase and new economic forecasts providing a first glimpse into whether the U.S. election has reshaped the central bank’s growth and inflation outlook.

A police officer keeps watch in front of the U.S. Federal Reserve in Washington October 12, 2016. REUTERS/Kevin Lamarque/File Photo

Fed fund futures show a 97 percent probability that the Fed will lift rates by a quarter of a percentage point at the end of its two-day policy meeting on Wednesday, according to the CME Group.

All 120 economists in a Reuters poll expect a rate hike in the wake of a string of solid U.S. economic reports.

More telling will be whether the stock market rally and jump in bond yields triggered by Trump’s Nov. 8 victory will push the Fed to an inflection point of its own and a higher projected pace of rate increases for 2017 and beyond.

The Republican businessman is inheriting a good economy, one that grew by 3.2 percent in the third quarter, the fastest pace in two years. There are, however, concerns that his plan to reduce taxes, cut regulation and increase infrastructure spending could not just boost the economy but also fuel higher inflation.

Since first published in 2012, the Fed’s quarterly “dot plot” of projected interest rates has generally moved in one direction – down – and any post-election change will show whether policymakers expect Trump’s policies to shake things up.

As of September, Fed officials’ median projection was for two rate increases next year and a long run “neutral” level of 2.6 percent. A rate increase this week would be the first since last December and only the second since the 2007-2009 financial crisis.

“Their path is going to move up faster and a little sooner,” said Steve Rick, chief economist for CUNA Mutual Group. He said the economy was running at its potential, and that was the Fed’s cue to “exit stage right” and steadily move rates to normal.

Fed officials have long hoped that other government policies would take the place of monetary engineering, which some believe may have lost its effectiveness in lifting economic growth.

They have warned in recent weeks that any new government spending should specifically be designed to boost productivity in an economy that is already near full employment and facing a high public debt burden.

The Fed’s new forecasts will indicate if policymakers feel that the monetary-to-fiscal handover is on the horizon, or need more time for the Trump administration’s plans to become more detailed and move through Congress.

Fed Chair Janet Yellen is scheduled to hold a press conference at 2:30 p.m. (1930 GMT) on Wednesday to elaborate on the economic outlook and policy statement.

She’ll have a broad set of issues to cover since her last press conference in September - from the Federal Open Market Committee meeting itself, to the likelihood she will be replaced in early 2018 and the risks she foresees from the Trump agenda.

Trump repeatedly attacked Yellen during the election campaign, accusing her of holding down rates to help his Democratic rival. Since the election, he has expressed his disapproval of corporate America, criticizing Boeing (BA.N), and took credit for a deal to keep hundreds of jobs at an Indiana plant from being moved to Mexico.

The president-elect also will be under scrutiny after this week’s Fed meeting for clues about how he plans to handle his relationship with the central bank.

“There is a real risk that he could be openly critical of the decision to raise rates next week,” Paul Ashworth, an economist with Capital Economics, said in a note last week.

That could upset markets and raise serious issues about whether Trump intends to leave the Fed alone or try to influence its decisions. Top U.S. elected officials, in particular the president, typically avoid criticizing the Fed’s short-term rate decisions, emphasizing instead the need for monetary policy to be set independently.

“If he remains silent after the announcement to raise interest rates next Wednesday, then we can begin to assume that it will be business as usual for the Fed,” Ashworth wrote.

WATCHING THE MARKETS

Trump’s plan to cut taxes and regulation and funnel fresh billions into capital projects must pass Congress, and it may be well after that before any new programs meaningfully effect economic forecasts.

But policymakers also watch the markets closely. It may be hard for the Fed to stick with its ultra-slow pace of rate hikes if a major tax overhaul and fiscal spending plan are unleashed.

TD Securities analysts said that fiscal policy at this point in the economic recovery could prompt “an inflationary demand shock” that adds nearly a percentage point to economic growth, but spurs the Fed to raise rates much quicker than expected - by nearly an extra percentage point per year.

That scenario of a central bank caught behind the curve and forced to act faster is one that Yellen and other policymakers have said they hope to avoid out of fear it could prompt a recession.

Fed officials in recent days have acknowledged the Trump agenda may cause them to switch gears, though it is not clear how soon.

“At this juncture, it is premature to reach firm conclusions,” New York Fed President William Dudley said last week.

But, since Trump won the election, Dudley added, “the stock market has firmed, bond yields have risen and the dollar has appreciated ... Market participants now anticipate that fiscal policy will turn more expansionary and that the (FOMC) will likely respond by tightening monetary policy a bit more quickly than previously anticipated.”

For a graphic on The Trump inflection, click: here

Reporting by Howard Schneider; Additional reporting by Ann Saphir in San Francisco and Jonathan Spicer in New York; Editing by Paul Simao

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