Macro Signposts | 17 July 2024

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Prescriptions for U.S. Monetary Policy Amid Growing Public Policy Uncertainty

The rising odds of former President Donald Trump's reelection have increased economic uncertainty and present unique challenges for the Federal Reserve. The potential policies of a Trump administration further support our argument in last week's Macro Signposts: The U.S. Treasury yield curve, which remained inverted in the first half of 2024, could resume steepening in the second half.

Although Trump's policies may increase risks for both inflation and recession, the timing, scope, and magnitude of their effects remain highly uncertain. Thus, we believe the Fed may stay the course for now by starting to gradually adjust policy toward estimates of neutral in line with Taylor-type rule prescriptions, initiating this process as soon as September. Once they start moving toward neutral, Fed officials would have the flexibility to assess their impact on the economy but also to react more forcefully as they assess the details and economic risks of the next administration's policy priorities. In other words, monetary policy shouldn't necessarily react to growing uncertainty associated with Trump policies by keeping policy on hold where it is today.

In the meantime, markets may interpret this pattern of shifting monetary policy as a reason for the yield curve to steepen.

Markets and the Fed
When considering how monetary policy should react to increased uncertainty, we must first discuss the so-called Brainard principle of uncertainty and "attenuation." Introduced in a 1967 paper by economist Bill Brainard, this principle suggests that when central bankers are uncertain about the impact of monetary policy on the economy, they should respond more cautiously to shocks than if there were no uncertainty. As Fed Chair Jerome Powell explained in his 2018 Jackson Hole address, "When unsure of the potency of a medicine, start with a somewhat smaller dose."

This principle, along with the arguments of others like Milton Friedman (who coined the famous phrase "long and variable lags" to describe the effects of changes in monetary policy) that uncertainty is pervasive, led to the proliferation of simple monetary policy rules designed to work on average across a range of conditions. These rules have evolved since Friedman suggested a simple money supply growth rule to what we now know as Taylor-type rules (after economist John Taylor). They can include specific mathematical terms to make policy more inertial; i.e., the optimal policy today is simply yesterday's policy rate plus small adjustments for economic developments.

However, acting slowly in response to uncertain economic shocks isn't always the best strategy. Since the 1960s and 1970s, extensive research has shown that there are two exceptions to attenuation and gradualism.

Monetary policy outlook
So where are we today? Comparing the current policy rate to a range of prescriptions of Taylor-type rules suggests - hypothetically - that current policy is too restrictive. Specifically, the moderation of inflation over the last two years, along with the modest rise in unemployment, argues for the policy rate to be around 200 basis points lower than it is today, according to simple prescriptive rules - see Figure 1.

Figure 1: Realized target fed funds rate (upper bound) vs. Taylor-type rules
Chart01
Source: Federal Reserve Bank of St. Louis, Haver Analytics, PIMCO calculations as of June 2024

Fed officials haven't started cutting rates due to uncertainty over how their policy might affect inflation, warranting an "attenuated" reaction. They don't want inflation to reaccelerate, resulting in the need to hike again, similar to the "stop-go" monetary policies of the 1970s. However, with recent inflation data - particularly owners' equivalent rent - once again moderating, we believe the Fed is likely to start gradually cutting rates soon (September is our baseline for an initial cut), aiming to reach a neutral rate by 2026.

Rising policy uncertainty associated with the rising chances of a second Trump presidency should also be taken into account. And we would argue that Trump's proposed policies increase the risk of both more persistent inflation (tariff policies should be one-time price level adjustment, but after the post-COVID inflationary period, they could lead to increased inflation expectations) and higher recession risks (his trade policies are large in scope and scale, and because the U.S. doesn't have the capacity to offer alternatives to imports, they could materially hurt growth). As a result, the best risk-based approach for the Fed may be to bring monetary policy back to neutral, so potentially aggressive actions can be taken as policy details become clearer.

The timing and implementation of policies also matters, and the Fed will have to react to evolving economic developments between now and then. If Trump's first term is a guide, new policies on taxes or spending may not be enacted until a year or two into his presidency. Theoretically, Trump has more control over tariff policies, such as his proposal to levy 10% tariffs on trading partners on day one of his presidency. However, in his first term, it wasn't until March 2018 that he announced 25% tariffs on $50 billion of Chinese goods, and the first "tranche" of tariffs wasn't imposed until June of that year. Similarly, any tax policy changes would require an act from Congress, which would take time even if Republicans have simple majorities in the House and Senate.

The bottom line
A potential Trump presidency increases economic uncertainty and presents challenges for the Fed. However, rising uncertainty about future policies may not warrant the Fed maintaining the current policy rate for longer. The details will be important for the Fed to assess the balance of inflation and growth risks. The timing will also be important, because the Fed will need to adjust policy to the developing economic conditions before any potential policies may be in place.

Eventually the Fed may need to act more forcefully, but gradually moving policy back toward a more neutral stance still seems like a reasonable approach to position for the growing range of potential scenarios.

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