Of the many adjectives that will be used to describe Donald Trump's presidency – and we can be sure there will be some colourful ones – one that has emerged even before the shock of his election victory fades is "inflationary." And that's the one that has suddenly complicated the job of the Federal Reserve Board, and may eventually put its chair, Janet Yellen, on a collision course with the soon-to-be president.
Economists' post-election analyses have widely agreed that the economic policies Mr. Trump outlined in his campaign are likely to accelerate U.S. inflation on several levels. His plans to cut taxes, and to increase spending on infrastructure, would massively expand the U.S. federal deficit (inflationary) while providing stimulus to accelerate the U.S. economy (inflationary). His threats to abandon free-trade deals and impose large tariffs on goods from China and Mexico would make a wide range of goods more expensive for American consumers (inflationary). His pledge to deport millions of illegal immigrants would significantly reduce the supply of workers in an already relatively tight U.S. labour market, which would push up wage pressures (inflationary).
As financial markets attempted to digest the ramifications of Mr. Trump's unexpected win in the past couple of days, this inflation story has increasingly coloured their thinking about what the Trump presidency means for the Fed's interest rates.
Initially, traders reduced their expectations that the Fed would raise its key federal funds rate at its next policy meeting in mid-December, on the thinking that the election of the controversial candidate would trigger a financial market sell-off that might cause the Fed to at least delay its widely expected rate increase.
But after the markets showed surprising resiliency to the election outcome – indeed, they seem to have warmed up somewhat to the stimulative potential of Mr. Trump's spending plan – the focus has quickly turned to the inflation outlook under Mr. Trump. Traders are now pricing in a near-certainty that the Fed will increase its rate by a quarter-percentage point next month. The question after that is how much Mr. Trump's early months in office will ratchet up the U.S. inflation trajectory – and, by extension, the Fed's pace of interest rate increases.
Like most modern central banks, the Fed's monetary policy is guided (at least in part) by a mandate to maintain low, stable inflation. Interest rate increases are its primary tool for cooling price pressures when they build in the economy. Assuming the new Trump administration moves ahead on the president-elect's agenda, the Fed will face additional price pressures that will push inflation up faster and higher than it had previously been anticipating.
"Soon enough, the president-elect might have to deal with a Fed that needs to accelerate the pace of its monetary tightening," Benjamin Tal, deputy chief economist at Canadian Imperial Bank of Commerce, said in a research report Thursday.
This is where things get sticky for Mr. Trump – and for Ms. Yellen.
As Mr. Tal points out, Mr. Trump set a goal during the campaign to accelerate growth in real gross domestic product to more than 4 per cent annually – roughly double the pace of the past five years. It's a lofty target; the Fed's latest projections, in September, forecast growth of about 2 per cent a year over the next three years. But if the Fed is accelerating its pace of rate hikes to address rising inflation, those rate increases would have the effect of cooling economic growth – working against Mr. Trump's ambitious goals.
Mr. Trump has made it clear he's no fan of Ms. Yellen; during the campaign, he accused her of manipulating interest rates to make the Obama government look good and enhance the election chances of his Democratic rival, Hillary Clinton. Many pundits took his unprecedented criticism of the Fed boss as a challenge to the Fed's fiercely guarded independence from political interference – and possibly evidence that he would seek to replace Ms. Yellen as chair of the Fed if he won the presidency. If Fed rate hikes threaten to get between Mr. Trump and his economic ambitions, no one would be surprised to see the new president ratchet up the pressure on the Fed chief.
Under the Federal Reserve Act, a president doesn't have the power to fire a Fed chair without "cause" – which, while ill-defined, is assumed to require a near-criminal level of malfeasance. And it wouldn't be in Mr. Trump's best interest to try to extract a resignation from Ms. Yellen anyway – the financial market instability generated by such an unheard-of move could be even more damaging to his economic aspirations than if he simply left the Fed to do its job.
But Ms. Yellen's four-year term as Fed chair expires in February, 2018, barely a year after Mr. Trump takes office. If Mr. Trump's policies and their inflation consequences come to pass, it's hard to see Mr. Trump offering her a second term. Mr. Trump's inflationary agenda could cost Ms. Yellen her job.