The Fed has started rethinking inflation in ways that could reshape the yield curve, Fed remittances to Treasury look set to drop, banks could become sellers of munis, Puerto Rico avoids the worst and tax reform bites high-priced housing. Contributions from Barclays, DB, GS, NY Fed and Milepost.
Markets/economy: The Fed rethinks inflation
The Fed may take a dovish tilt in the years ahead and tolerate a bit more inflation, according to Deutsche Bank Chief Economist Peter Hooper. He attended the Brookings Institute’s Jan 8 conference on inflation targeting along with former Fed chair Ben Bernanke, economists Larry Summers, Olivier Blanchard, Rick Mishkin, John Taylor and others. The debate focused on ways to give the Fed enough room to ease in the next recession. Bernanke and San Fran Fed President John Williams argued for targeting 2% inflation on average. Shortfalls during recessions would have to be followed by higher inflation during expansions. That would produce much more volatility in the shape of the yield curve than the market has seen historically, but it would help the Fed in markets where fed funds were floored at zero. Materials from the conference are here. See Deutsche Bank, Fed Note: Brookings Fed policy framework discussion, 10 Jan 2018. See also Goldman Sachs, Price Level and Nominal GDP Targeting: New Frameworks for the Fed?, 14 Jan 2018. (DB, GS, Milepost).
Markets: DC rethinks its favorite P&L
The Fed’s $4.5 trillion portfolio has sent hundreds of billions of dollars to the US Treasury in the last decade and helped trim US deficits, and now the NY Fed has projected how those remittances will change as the Fed lets its portfolio run down. Expected annual remittances should drop from more than $70 billion currently to around $40 billion by 2020 as the Fed pays banks higher interest on excess reserves and as securities run off. But as IOER plateaus and the Fed begins reinvesting run-off again, remittances start to climb as new purchases come into the portfolio at higher yields. By 2030, the Fed could be putting more than $100 billion a year in the Treasury. The NY Fed looks at the risk that IOER could rise so quickly that the Fed pays out more than it takes in, something that could create political problems for the central bank. Most plausible scenarios in the NY Fed analysis show the risk of Fed shortfalls at less than 5%. The NY Fed post is here. (NY Fed, Milepost).
Markets/banking: The muni market faces possible bank selling
Tax reform has almost certainly changed the way that banks evaluate municipal bonds, according to Barclays, putting more than $200 billion potentially in play if rates and spreads make other investments more attractive. The drop in the top corporate tax rate from 35% to 21% has revived memories of 1986 tax reform, when the top rate dropped from 46% to 34% and bank holdings of muni debt dropped from $235 billion to $100 billion. Banks currently hold more than $300 billion of muni debt with $220 billion readily salable. Of course, it will take compelling alternatives, but Treasuries and MBS could create competition. See Barclays, Bank Appetite for Munis Under the New Tax Regime, 11 Jan 2018. (Barclays, Milepost).
Economy: Puerto Rico dodges the worst case – so far
Despite continued power outages, water shortages and travel and telecommunications problems since Hurricane Maria hit on Sep 20, Puerto Rico so far has escaped a worst-case hit to economic output, according to the NY Fed. Employment in Puerto Rico in October and November plunged with tourist sectors hit hardest and wholesale trade, health and education also showing steep losses. However, initial losses look consistent with those from other major hurricanes, which saw employment and output rebound over 12 to 18 months. The employment data may not be reliable, but other economic data show a similar pattern. The huge impact of the hurricane on general quality of life could accelerate emigration from Puerto Rico, which could push the island into a downward spiral. But initial signs look far from catastrophic. The NY Fed post is here. (NY Fed, Milepost).
Markets/economy: Tax reform to bite high-priced housing
Most of the impact on housing from recent tax reform should fall around New York City, New Jersey, southern Florida, coastal California, Chicago and parts of Texas, according to Morgan Stanley. The cap on state and local tax deductions should take the biggest bite while limits on the mortgage interest deduction and a doubling of the standard deduction should have small effects. The latest work continues analysis done years ago by the Cleveland Fed and PwC that suggest home prices in some markets could drop by 10% or more. See Morgan Stanley, A Tax on Both Your Houses, 12 Jan 2018. (MS, Milepost).