Despite interest rates being at elevated levels, the economy hasn’t weakened the way many had forecast. In a research note, Evercore ISI examines the effect that the Fed’s fiscal policy is having on interest rates, noting that compared to a pre-Covid baseline it probably still is stimulating the economy.
In other words, wrote analysts, “fiscal policy has pushed up the short-run neutral rate r*.”
The impulse from fiscal policy is however likely to moderate over the next 12-18 months which would bring the short-run r* down.
Evercore’s analysis employed a measure of the impact of fiscal policy by the Hutchins Center on Fiscal and Monetary Policy. Using this, they determined that fiscal policy is still boosting the economy by the equivalent of 0.7% GDP relative to a 2019 baseline. This estimate includes effects via household or business spending.
“If the Fed were to set policy to fully offset that stimulus, it would need to engineer long-term interest rates—such as the ten-year Treasury yield—that are nearly 25 basis points higher than in 2019,” wrote analysts in the note.
This would entail setting the Federal Funds rate about 70bps higher than otherwise.
An additional approach used by Evercore to determine the effect fiscal policy is having is the ‘optimal control’ model-based assessment. In order to offset fiscal stimulus today, this approach suggests the Federal Funds rate would have to be about 125bps higher than if there had been no stimulus.
This would explain why policy doesn’t appear very restrictive today, observed analysts.
Both approaches also suggest a timeline for when the impact of fiscal stimulus will be offset. According to the Hutchins-based measure, the fed funds rate to offset stimulus would fall by 70bps by the end of 2025 (with the fall beginning by mid-2024).
According to the optimal control method, the boost to the fed funds rate would fall by 100bps by the end of 2025.
“This suggests that 70bp to 100bp of cuts might be needed through end next year to offset fading fiscal support and the associated decline in short-run r*, separate from other considerations that will shape the rate path,” added analysts.
Biden vs Trump
The report also considered the implications of the U.S. elections on fiscal policy. Importantly, Trump’s first-term tax bill is set to expire at the end of 2025.
If he were to become President again, the Tax Cuts and Jobs Act will likely be extended; meanwhile, Biden would partially repeal the act.
Biden’s approach is estimated to lead to a fed funds rate that’s 25bps lower than if the TCJA were to be extended under Trump.