Yellen’s Path Cleared By Trump’s Moderation

There is a lull in the maelstrom launched by the Trump Administration. His ban on immigrants from seven of the ten Muslim-majority countries in the Middle East has been stymied by the judicial system that has emerged as a check on the assertion of executive authority but is on its way to the Supreme Court. He backed off after goading China by threatening to recognize Taiwan. 

After accusing Japan of manipulating its currency, Trump reportedly did not broach the topic with Prime Minister Abe in their meeting before the weekend. The Administration also eased some concerns by underscoring its commitment to NATO, despite Trump’s claim it was obsolete. Contrary to earlier reports, the US apparently has agreed to continue sanctions against Russia associated with the aggression in Ukraine. After seemingly encouraging a more aggressive Israel, President Trump warned that its construction efforts on the West Bank were not helpful for peace. 

Not only did Trump move back toward more traditional positions, but he also threw investors a bone. Investors and businesses have been eager for more details on the President’s economic agenda. After meeting with airline executives, Trump announced that “phenomenal” tax reform was a few weeks away. This seemed to be just what some investors wanted to hear, and the major equity indices were goosed to new record highs, and the US dollar had its best week of the New Year. 

At the same time, the President’s tweets may be losing their market impact. The retailer that dared drop his daughter’s clothing line was subject to a critical tweet, and the stock rallied. The Mexican peso, which had dramatically depreciated under a barrage of criticism from Trump staged a recovery. Since January 19, the peso has been the strongest currency in the world. 

The prospect of a border adjustment (tax imports and remove taxes on exports) has prompted many classically trained economists to claim that the dollar will automatically appreciate offsetting the import tax. While we retain our long-term constructive outlook for the dollar, we are skeptical of what still strikes us as a naïve understanding of purchasing power parity and a misuse of economic identities. Their case rests on the dollar’s exchange rate being the burden of adjustment. There is an alternative moving part, the general price level. That is to say, the result of the import tax could be higher inflation. 

This brings us to Fed’s chief Yellen’s Congressional testimony. There are three main issues. First is the economic assessment. Little has changed since the FOMC statement.The Federal Reserve appears more confident in the resilience of the economy and the continued recovery in price pressures. She is unlikely to pre-commit the central bank to raising rates at any meeting, but will likely reiterate that the commitment to gradually normalizing monetary policy.