When US Federal Reserve Chair Jerome Powell faces the media after the central bank’s policy-making meeting next week, he’ll probably get a politically fraught question: How will the Fed incorporate president-elect Donald Trump’s stated plans — including tax cuts, tariffs and deportations — into its economic outlook and monetary policy?
In November, Powell’s response was categorical: “We don’t guess, we don’t speculate, and we don’t assume.” This time around, he’ll have to be more nuanced.
In fact, the Fed can and must at times make assumptions about what politicians will do. Back in December 2016, when I was vice chairman of the policy-making Federal Open Markets Committee and Trump had just been elected to his first term, the staff forecast assumed that “Congress will pass a personal income tax reduction worth 1 percent of GDP, to begin in the third quarter of next year.”
At the time, I asked the staff a question similar to what Powell will likely get: “What’s the threshold for deciding to put something in for trade barriers going up or immigration policy being tightened?” Based on the answer then and my experience at the Fed, I see four criteria.
First, there has to be a strong likelihood that a policy shift will take place.
Second, the shift must be large enough to have meaningful consequences for economic growth, employment, inflation or financial conditions, including stock prices and interest rates.
Third, the Fed needs some clarity about what the policy will be. In December 2016, potential tariffs weren’t incorporated in the forecast. As Steve Kamin, then head of the Fed’s Division of International Finance, put it, the possibilities were “so disparate” and their magnitude “so difficult to gauge” that the staff “chose not to assume.”
Fourth, if stock and bond markets have come to expect a policy shift, it’s hard to ignore. That’s one reason the tax cuts made it into the December 2016 forecast. “It was clear that financial markets participants made a judgment that something is likely to be in the offing,” David Wilcox, then head of the Fed’s Division of Research and Statistics, said at the time. Backing those expectations out of the forecast would be an unduly cumbersome and “elaborate process.”
How, then, can Powell proceed? I think he’ll follow the example of 2016. He’ll say that the Fed anticipates an extension of the 2017 tax cuts and has incorporated this in the forecast — but that no adjustments have been made regarding tariffs or deportations. Incorporating the tax-cut extension makes sense, because it’s highly likely and large. The trade and immigration policies, by contrast, remain too uncertain, just as in 2016.
Powell won’t be able to indicate how any of this affects the FOMC’s Summary of Economic Projections, because committee members aren’t bound by the staff’s assumptions. That said, I expect they’ll largely follow the staff, incorporating only a continuation of current tax policy. As a result, their forecast will be rosy, with no penalties to growth, inflation, productivity or labor supply from tax increases, tariffs or deportations.
Specifically, I expect the median projection to entail slightly stronger growth in 2025 and 2026 compared with the September median forecast, reflecting persistent momentum in the economy and a higher productivity growth trend. The unemployment rate will remain slightly above the level that Fed officials judge consistent with stable inflation. Inflation will decline to the Fed’s 2% objective, most likely in 2026. By 2026 or 2027, the federal funds rate will fall to what the Fed sees as the neutral level consistent with 2% inflation. This path will likely involve just 50 to 75 basis points of rate cuts in 2025 (compared with 100 basis points in the September 2024 projections), and a slightly higher neutral rate — probably 3% or more, but considerably below the level that futures prices currently imply.
The underlying narrative will be the same as in September: As the labor market loosens and inflation recedes, monetary policy will gradually move from restrictive to neutral, likely achieving a soft landing. When the Trump administration’s tariff and deportation policies come into focus, that outlook may become less rosy.
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