Economic Commentaries

05

As the old year ended and a new one begins, the economy and financial markets grapple with three basic domestic issues. These are prospects for fiscal policy; the machinations of voter preferences for the next President; and the Federal Reserve's policy prescription as it affects economic growth and interest rates. None of these seem favorable.

On fiscal policy a compromise omnibus spending bill was passed late last year, avoiding any near term government shutdown. But in doing so lawmakers offered a modicum of fiscal stimulus by agreeing to abandon the sequester caps imposed by the 2011 Budget Control Act. So much for fiscal discipline while nothing was accomplished on the important issues of tax and regulatory reform that might actually aid economic growth.

On the political front it hardly seems likely that tax and regulatory issues will be addressed this year. Indeed, on the democratic side if anything candidates are promising more taxes and more regulation. The republican field remains wide open with fringe candidates exhibiting considerable staying power. Republicans might address tax and regulatory reform in a new administration but concerns over governance could be unnerving.

Then there is the data dependent Federal Reserve. Through most of 2015 the Fed continually shied away from hiking interest rates because of wobbly growth and too low inflation. A rate hike was finally delivered in mid-December as the FOMC cited an improving economy and a presumed subsiding of the temporary factors holding down inflation. However, with the exception of labor market reports every economic data point signaled increasing rather than lessening weakness. And the temporary factors of wage stagnation, low energy prices, and a strong dollar exchange rate appear more permanent than transitory.

Importantly the ISM registered two consecutive contraction readings at year end and housing demand faded significantly This is admittedly hard to square with hefty job additions in recent months although weird weather could be distorting the numbers while growth inhibiting tax and regulatory policy creates a boom in professional and business service payrolls.

The Fed's internal forecast for interest rate hikes in 2016 is more aggressive than current market expectations. This breeds more uncertainty for financial markets at a time when earnings are under pressure and economic growth may not be sufficiently strong to handle such actions. Every Central Bank that raised interest rates since 2008 has had to reverse course. We sense that financial markets are thinking the Fed may have to do so as well. The more important question is that if a course reversal is needed, will the Fed admit it and do so in a timely manner. History would suggest a healthy skepticism on this matter.

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