Even though interest rates are at elevated levels, the economy has not weakened as many had predicted. In a research note, Evercore ISI analyzes the impact of the Fed’s fiscal policy on interest rates, noting that relative to pre-Covid baselines, it is still likely to stimulate the economy.
In other words, analysts write, “fiscal policy has led to an increase in the short-term neutral rate r*.”
However, fiscal policy momentum is likely to weaken over the next 12-18 months, leading to a decline in short-term r*.
Evercore’s analysis used a measure of the impact of fiscal policy conducted by the Hutchins Center on Fiscal and Monetary Policy. Using this, they determined that fiscal policy still stimulates the economy by an amount equivalent to 0.7% of GDP over the 2019 baseline. This estimate includes the impact of household or business spending.
“If the Fed were to set policy to fully offset this stimulus, it would have to craft longer-term interest rates—such as the 10-year Treasury yield—that would be nearly 25 basis points higher than in 2019,” the analysts wrote in a journal note.
This would entail setting the federal funds rate at about 70 bps. higher than otherwise.
An additional approach used by Evercore to determine the effect of fiscal policy is an “optimal control” model estimate. This approach suggests that in order to offset fiscal stimulus today, the federal funds rate would need to be about 125 bps higher. higher than if there were no incentives.
That could explain why the policy doesn’t appear very restrictive today, analysts say.
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Both approaches also assume a time frame for when the impact of fiscal stimulus will be offset. Hutchins estimates that the federal funds rate to offset the stimulus will fall 70 basis points by the end of 2025 (the fall will begin by mid-2024).
According to the optimal control method, the increase in the federal funds rate will decrease by 100 bps. by the end of 2025.
“This suggests that a 70-100bp cut may be needed before the end of next year to offset weakening fiscal support and the resulting decline in short-term r*, separate from other considerations that will shape the path of rates,” analysts added.
Biden vs Trump
The report also examines the implications of the US elections for fiscal policy. It’s important to note that Trump’s first-term tax bill expires at the end of 2025.
If he were to become president again, the Tax Cuts and Jobs Act would likely be extended; Biden, meanwhile, will partially repeal the law.
Biden’s approach is estimated to result in the federal funds rate being 25 basis points lower than if the TCJA had been extended under Trump.