Post Tax Reform: The Financial Journey Ahead
What are the “real” impacts of the tax plan?
If you asked 10 economists what the impact of the tax plan is to the general economy, you would get 11 answers. In a nutshell the tax plan is meant to “juice” the economy by freeing up working capital from businesses.
The “theory” behind the tax cut is that businesses will reinvest this capital and therefore continue to drive the economy. I emphasize the word “theory” since nobody really knows what is going to happen. This is not tax reform as the tax code will only get more complex with the proposed changes. Many of the provisions are set to “sunset,” and therefore businesses likely will not make too many structural changes since long-term the rules could change. Furthermore, the economy is already running on all cylinders so what impact will a sudden influx of capital have?
The markets don’t seem to be buying the notion that the tax changes will alter the growth of the economy over the long term. The best indication of long-term growth is 10-year treasuries. Basically, treasuries price in future “growth.” In a “growth” environment the economy would heat up, workers would be paid more and businesses would be able to raise prices. This equates to inflation; long-term treasuries predict future inflation. If the economy is really going to grow, why have long-term treasuries basically stagnated since the tax cuts were announced? The market is clearly not buying the theory that economic growth will begin increasing due to the tax cuts.
WHY TREASURIES ARE AN IMPORTANT INDICATOR?
In an inflationary environment, longer-term treasuries would decrease (rates would increase since rates move inverse with price on bonds). This has not occurred and therefore the market is telling us that something drastically different is anticipated.
WHY DOES TIMING MATTER?
Basic economics tells us that simulative policies should be used to spur growth when the economy is faltering. As the economy improves, these simulative policies should be scaled back. I think few would argue that in today’s economy simulative policies are likely not needed since the economy is performing quite well with moderate growth and low inflation. By spurring growth this late in an economic cycle there is risk of overheating the market. The market is unable to structurally go any faster and as more stimulus is added it further stresses the market. For example, the employment rate is close to zero in many cities, as the economy heats up, inflation is likely to occur in the short-term, which leads to actions by the Federal Reserve to control the “heated” economy.
WHAT WILL THE FEDERAL RESERVE DO?
The Federal Reserve’s job is to try to “smooth” out the economy so that it does not get overheated from inflation or crash and burn due to a recession. It also helps stabilize the economy when growth rates are anemic. Monetary policy (like the raising of interest rates) utilizing overnight rates is one of their key tools to help guide the economy. For example, to counteract current inflation or anticipated inflation rates could be raised to “temper” the inflationary pressures. Today, the federal reserve is not waiting for the inflation train to leave the station, they are trying to “get ahead” of the inflation by raising rates now. The proposed tax cuts add further fuel to the fire.
SHORT-TERM RATES WILL RISE
The Fed has hinted at three rate hikes for 2018 in anticipation of future inflation/stimulus from a tax bill. These rate hikes are moving short-term rates higher and the market is pricing this in. Bloomberg recently came out with an article titled: Investors told to brace for steepest rate hikes since 2006. The increase in short-term rates will flow through to consumers and businesses in higher rates on credit cards, car payments, etc.
WHAT’S THE PROBLEM?
It is a fine balancing act to counteract inflation while at the same time not eliminating growth and spending. This is especially difficult since the markets are forecasting little inflationary risk. The 10-year treasury has barely budged. It is almost as if the Federal Reserve is chasing a mystical inflation ghost that has yet to materialize. This lack of future growth means incremental rises in short-term rates have a much higher probability of crimping economic growth too much.
THE RECENT TAX PLAN PROVIDES MORE AMMUNITIION TO THE FED TO CONTINUE RAISING RATES IN THE SHORT-TERM
This increase in rates will no doubt crimp consumer and business spending, which will trigger a further reduction in our economic growth rate. This raise in rates due to “anticipated” heating of the economy from the tax cuts will not only counteract the tax cuts but will likely spur the next cycle.
IS IT THE CHICKEN BEFORE THE EGG?
Will tax cuts cause the next cycle or will the Federal Reserve’s reaction to the tax cuts be the culprit?
I don’t think anyone really knows what the ultimate culprit will be. Regardless if it were the chicken or the egg there is no doubt that the economy is entering dangerous waters that will be impossible to navigate without any disruption to the economy. Now is a good time to financially get ready for the journey ahead.