Adjustment vs. normality
As the world adjusts to the new reality of a split Congress after the midterm elections in the U.S., the Federal Reserve seems to be on track for a December hike after Thursday’s policy statement. Global equities have marched higher in line with their usual pattern after U.S. midterm elections. Positioning adjustments among hedge funds have contributed to the move higher in equity indices, as they were generally positioned for weaker risk appetite going into the midterm election. The likelihood of a debt ceiling battle (possibly prolonged) next year has increased while chances of further fiscal stimulus have been dented by the outcome.
The Democrats may indeed try to convert the White House into a “24/7 legal defense operation” once they convene in the House on January 3 via an onslaught of legal probes. But it’s not as if the President or the Republicans are powerless, having control of the Executive Branch, the Senate and the Supreme Court. And the first shot in next year’s political battles may already have been fired when Trump decided to replace Attorney General Sessions with Matt Whitaker (a critic of Special Counsel Mueller and his Russia probe).
An escalating trade war and increased uncertainty about the policy course will be a burden for sentiment. Further, a divided Congress is unlikely to be able to prevent fiscal policy from tightening in 2020, which will happen under current law. Tightening fiscal policy together with tighter monetary policy it set to hit growth especially in 2020, increasing the odds of the U.S. economy hitting recession that year.
Also, both Democrats and Republicans want to cut taxes on the middle class and invest in infrastructure. Democrats wouldn’t mind reinstating the portion of the state and local taax deduction that was scrapped by the Tax Cuts and Jobs Act. President Donald Trump wants a border wall, but he also wants his tax returns left unexamined by Congress. So while there’s common ground, there seem to be few compromises that would save money. That’s a problem because the federal government will already spend $4.5 trillion in 2019, paid for with $3.5 trillion in taxes.
More interesting globally is the U.S. core inflation number, which will be announced on November 14. Weaker unit labor cost growth and a stronger dollar point toward risks of lower core inflation in the near term. Core inflation has undershot expectations two times in a row, and this has not affected the Fed. The Fed is convinced that the Phillips curve is alive and kicking, and hence ready to tolerate some undershooting inflation numbers.