WORLD MONEY
For financial markets, last week was as eventful as it could get. For one thing, the appointment of the new US Federal Reserve boss was announced. Jerome Powell, the new chief who takes over in February 2018, is a mild-mannered centrist and monetary policy is likely to continue on the gentle course mapped by current Chairperson Janet Yellen. This does not mean the Fed would not hike rates further. In fact, going by the release from the Federal Open Market Committee meeting (yet another heavy-duty event) last Wednesday, the US monetary authority is likely to hike the signal Fed Funds rate by a quarter of a percentage point when it meets next in December. More hikes are due next year.
However, what is critical for the markets is that all these hikes are anticipated and “priced in” to things such as exchange rates and stock prices. The new Fed boss is unlikely to deviate from this path and say hike rates more aggressively or roll back its money printing programme more swiftly than investors expect. These could have been risks if a hawk had been appointed instead. Markets, for instance, had dreaded the prospect of economist John Taylor of Taylor Rule fame, a card-carrying anti-inflation crusader, getting the job. For emerging markets (EM) including India, this should be good news. US interest rates will rise at a measured pace, the dollar is unlikely to see a spike and there should be enough juice left in the differentials between borrowing costs in the US and returns in the EMs to keep capital flowing in.
The bigger event was quite clearly the tax reform programme — Tax Cuts and Jobs Act that Republicans unveiled in the US Congress on Thursday. The key reform is the proposal to drastically reduce the corporate tax rate from 35 to 20 per cent. This would change the US’ status as the economy with the highest corporate tax rate among the G-20 economies to the lowest.
There are, predictably, overtures to the middle class in the Act to help Republican legislators “sell” this tax plan to their constituencies. Tax slabs have been reduced from seven to three, standard deductions have doubled and child tax credit has been increased. However, most calculations show that the actual increase in post-tax incomes might not be much and the gains are likely to be regressive, that is, the top income tiers will gain more proportionally than the bottom ones.
A couple of other things are likely to face resistance. First, deductions on state taxes (SALT) have been reduced and no taxpayer would be willing to let that pass without putting up a fight. Second, the Bill reduces the limit on interest deduction on mortgages. Real estate players and homebuyers are up in arms against this clause. Small and medium enterprises associations, too, have found fault with the Bill. Thus, Washington’s infamous but influential lobbyists are likely to have a field day trying to modify the current version to suit different groups.
However, unlike the attempts at repealing Obamacare, this Bill is likely to see the light of day, albeit with some changes. Financial markets are likely to welcome this. However, it remains to be seen how fund flows behave. Will this drive flow into the US markets at the cost of other markets (given shrinking global liquidity) or lift all boats at the same time? As economists, our concern lies with the boring bits beyond the near term such as the impact on the budget deficit and growth. The Republicans project that the cost of the Bill would be $1.5 trillion over 10 years, the maximum amount mandated by the so- called Byrd Rule.
The problem lies with its assumptions and the tax reform itself is projected to provide stimulus to take average growth over the next decade to three per cent. This compared to 1.9 per cent estimated by the non-partisan Congressional Budget Office. If growth fails to take off, all this purported reform would have achieved is a massive expansion in deficit. This will, among other things, drive a spike in interest rates. Not a happy scenario for the markets, is it?