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Market Prepared for Fed Moves

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Carl Tannenbaum. He's the chief economist at Northern Trust. We're going to look at the Fed's recent meeting, and what it could mean for the economy.

Carl, thanks for joining me.

Carl Tannenbaum: It's good to be here.

Glaser: Let's start by looking at the Fed's meeting that happened this week. Mostly as expected, but they did announce that they will begin the balance sheet normalization process. Do you think that the market is prepared for this, or are we going to see the taper tantrum again?

Tannenbaum: I think the Federal Reserve learned from its mistake in 2013, which was the taper tantrum, where then chair Ben Bernanke made a hint that they might start tapering their purchases. Markets reacted very poorly. This time around, really from almost the start of this year, the Fed began previewing that it intended to start reducing its balance sheet later on in the year. They gave a full outline of the program, actually three months ago. When the news came yesterday to begin that process, it certainly did not come as a surprise, and asset prices were pretty calm, as a result.

Glaser: One of the other notable aspects from the statement was that the Fed is still seeing inflation below their 2% target, but they're on track to raise rates again once more this year. Do you think it's realistic that inflation will come back up to that 2% level?

Tannenbaum: It's a tried and true technique in economics that if you miss your forecast, just change the date. In some sense, that's what the Fed has been doing with its forecast that we will ultimately get to 2% inflation. Years ago, they had thought that we'd be there by now, but recently, certainly, we've taken a step back.

The reason they still have confidence is that we are eight and a half years into an economic expansion. We do have very low levels of unemployment. While wage growth has been tame, the likelihood is is that it's going to trend upward in the quarters ahead. They, certainly to stay ahead of potential inflation, have committed, at least in their dot charts, to raising interest rates some more.

Glaser: If we are going to see higher rates, at least short-term rates, do you think that's going to have a big impact on the real economy? Can it support those numbers?

Tannenbaum: I think interest rates, of course, have a gradual impact on the economy. Let's not forget that interest rates, even at current levels, are awfully low. When you combine that with the fact that the Fed still has a big balance sheet, there's a lot of monetary support still in the system. The Fed did that in order to make sure that we got out of the crisis and put a floor under the economy. I think they're going to be very careful about removing that accommodation, so as they don't undo their good work. Both the balance sheet program and the interest-rate increases, I think, are going to be gradual and measured.

Glaser: When thinking about stock market valuations then, one of the supporting factors is low rates. You're not worried about Fed increases over the next couple of months potentially having a big impact there?

Tannenbaum: I'd offer a couple of thoughts. First, a lot of the market reaction will depend on how the Fed prepares the markets for what they do. So far this year, they've done a very good job of that. Secondly, when you're talking about interest rates, especially long-term interest rates, the Fed only has the slightest control over, let's say, the 10-year U.S. Treasury, which is also critical to stock valuations, because our Treasuries, for all of our challenges in Washington with debt and deficits, are still a very desired asset among global investors.

Glaser: We're going to switch gears just slightly for a final question. Also related to valuations is that we've seen, corporate tax reform seems to be baked in a little bit now. You've written that this is overdue. Could you talk a little bit about why you think corporate tax reform is important, and your thoughts about the likelihood of it actually happening.

Tannenbaum: I think it's a little unfortunate that too much focus has been put on changing the personal tax code, where the fiscal and political calculus are very, very difficult. The corporate tax code, however, is something that both Democrats and Republicans have expressed a desire to update, because our corporate tax rate is much higher than other developed countries. It puts us at a competitive disadvantage. We've seen investment, we've seen jobs, we've seen capital, go overseas that used to stay here in the United States. As a result, we have about $2.5 trillion of U.S. corporate profits that are stranded overseas, because to bring it home would trigger a big tax bill.

There's a formula there to bring those resources back home, generate some revenue, also generate potential job creation and investment. That sounds like a win-win-win situation.

Glaser: Carl, I really appreciate you taking the time to share these thoughts with us today.

Tannenbaum: My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.