Trump set to put an old foe in an uncomfortable position

When the US Federal Reserve Board’s Open Market meets for the last time this year it will be business as usual, but with a twitchy eye towards next year and Donald Trump’s controversial economic policies.

The meeting in Washington on Tuesday and Wednesday is expected to result in the Fed’s third rate cut in a cutting cycle that started in September. Futures markets have priced in a 98 per cent probability of a 25 basis point cut.

Fed chairman Jerome Powell is widely expected to deliver a rate cut on Thursday. Credit: AP

That’s despite recent inflation data showing that the US inflation rate has stalled, indeed has crept up marginally, and a jobs market that, while cooling, hasn’t cooled as much as the Fed had anticipated.

Recent comments from the Fed’s chair, Jerome Powell, and other Fed governors have reflected a somewhat more conservative tone than when the cycle began. Powell said the strength of US growth meant the central bank could afford to be a little more cautious as it tries to identify the neutral interest rate that neither stimulates nor suppresses growth.

While most Fed watchers believe it will cut its federal funds rate this week, they also think it will cut less next year than they, or the Fed itself, previously projected.

Back in September, the Fed’s famous “dot plot” showed the members of the Federal Open Market Committee (FOMC) that makes monetary policy decisions expected four rates reductions next year. The markets are now pricing in three, at best.

That’s partly because inflation has proven more persistent than anticipated and the jobs market more resilient.

For market participants, if not yet the Fed, there’s also some factoring in of the impact of Trump’s policy agenda, which includes tax cuts, tariffs on all imports, a 60 per cent tariff rate on imports from China and an unprecedented program of deportations of illegal immigrants.

Powell has said the Fed won’t take Trump’s policies into account at this week’s meeting.

“We don’t guess, we don’t speculate and we don’t assume,” he said in November, after the Fed’s last meeting, when asked how it might factor Trump’s plans into its decision-making.

“Here’s what we don’t know,” he said at a New York Times conference earlier this month.

“We don’t know how big they’ll [the impact of the policies] be. We don’t know the timing and duration. We can’t start making policy on that. We have to let this play out.”

That is a reasonable position to take. Until Trump takes office next month and starts trying to implement his policies, their detail, timing and, where necessary, their prospects for gaining congressional approval won’t be known. His immigration policies, in particular, are likely to face challenges in the courts.

Trump has, however, said that his tariffs – a baseline tariff of up to 20 per cent on all imports plus the punitive tariffs on China – can and will be implemented via an executive decision on “Day One” of his new administration. In his first term, as Joe Biden has done during his presidency, he was able to use his executive authority to impose tariffs.

Similarly, he has said that the administration will start executing his plan to deport millions of immigrants as soon as he takes office, although rounding up the numbers of people he’s talking about – 11 million or more – holding them in vast, yet-to-be-built detention centres and then deporting them will take many years.

Trump’s tax, trade and immigration policies would, if implemented as he has described them, lead to higher levels of inflation than would otherwise be the case.

The Peterson Institute for International Economics has estimated that the combination of Trump’s core economic policies would cause inflation to be 4.1 and 7.4 percentage points higher than otherwise by 2026, with the inflation rate peaking at between 6 and 9.3 per cent.

While the Fed might have the conviction that, if implemented as Trump has described them, the policies will be highly inflationary, it also knows the full effects of their impacts will materialise over time.

The Fed responds to data and feedback from financial markets. Until it has that data, feedback and clarity around their detail and timing, it is unlikely to factor the Trump policies into its decision-making. However, a former New York Fed president, Bill Dudley, has argued that it could incorporate an extension of Trump’s 2017 tax cuts, which would expire next year unless Congress extends them, into its forecasts.

‘We don’t know how big they’ll (the impact of the policies) be. We don’t know the timing and duration. We can’t start making policy on that. We have to let this play out.’

Fed chairman Jerome Powell

Those in the markets believe that, after cutting its policy rate this week, the Fed won’t move again until March at the earliest. It could, of course, keep rates on hold until it better understands Trump’s plans and their effects.

If Trump does what he has said he will do, with Republican majorities in the House and Senate making it easier to implement policies that require congressional approval, it is likely inflation and interest rates will rise again either late next year or in 2026.

That’s why there will be considerable interest in the projections of individual Fed members released after this week’s meeting and even more so when they are next issued in March.

Any shifts in expectations of where rates will be at the end of next year and in 2026 at each quarterly release of the projections will be interpreted as incorporating the FOMC members’ assessment of the impacts of Trump’s policies.

Trump has made it clear that he would like to remove Powell as the Fed’s chair and gain significant influence over the Fed’s decision-making, but appears to have concluded that he doesn’t have the legal authority to do so. Powell’s term as chair (but not as a Fed governor) ends in May 2026.

Thus, if he is able to extend (and even increase) his tax cuts, impose his tariffs and deport millions of immigrants, the potential for a clash between the Trump administration and the Fed between now and then is quite real and would destabilise global financial markets.

It is, however, highly unlikely that Powell will fan those flames and bring forward the almost inevitable confrontation with Trump at this week’s meeting. It will react to the incoming administration’s policies, not pre-empt them. Sometime next year, however, it may find itself in a different and quite uncomfortable position.

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