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Raft of unknowns make Fed direction tough to predict

Donald Kohn
Donald Kohn thinks the Trump administration will make the Fed’s job trickier.

Fed watchers trying to predict when and where interest rates will go in 2017 will have plenty of challenges, including a new president with an ambitious agenda, new members of the Federal Reserve's rate-setting committee and the U.S. economy itself.

Once rates do start rising, sponsors of defined benefit plans will be paying close attention to how that impacts their decisions about investments, funding, and, potentially, risk transfer.

Perhaps the biggest unknown is how much of Donald Trump's election campaign platform becomes reality, including promises of major new infrastructure spending, tax reform and economic growth initiatives and protecting Social Security and Medicare. He also has promised to revisit trade deals and reform the immigration system.

With Republicans controlling the White House and Congress, “the odds that major changes in tax, spending, trade and regulatory policies will affect the trajectory of interest rates are much higher than in the past,” Donald Kohn, a senior economics fellow at the Brookings Institution and a former vice chairman of the Federal Reserve, said in a recent blog.

Tim Hopper, managing director and chief economist at TIAA Global Asset Management, points out that “markets trade on expectations. (Mr. Trump) has a long list of promises. We'll know pretty quickly in his first 100 days how aggressive he will be. If we get everything, there's probably room for growth.

“The measuring rod for this next administration is going to be productivity growth,” he said.

Steven Friedman, senior economist at BNP Paribas Investment Partners in New York, noted that any economic stimulus could fade over time. “The question is, can you do something to shock the economy? The only way to do that is increased productivity,” he said.

Tax reform “is going to be something that we're going to be watching, before, during and after,” said Jim Caron, fixed income portfolio manager with Morgan Stanley (MS) Investment Management in New York. “The markets are going to start to pick sides.

“The U.S. in isolation is not sufficient,'' he said, adding that in 2017 he'll also be watching the dollar and the global economy. “It has to be additive to global growth.”

Conflict with White House

Paying for all of Mr. Trump's ideas, from tax cuts to increased military and infrastructure spending, also raises the possibility of conflict between the White House and Congress over deficit spending, said Mr. Friedman. “Deficit spending could provide a short-term boost to growth. Other the other side, a large increase in deficits could lead to higher interest rates.”

Mr. Kohn of Brookings, who praised members of last year's Federal Open Market Committee for their “amazingly accurate predictions in an uncertain and imperfectly understood economic environment,” noted they still were wrong in predicting their own actions one year ago, when no FOMC participant expected less than two rate increases in 2016 and most expected two to four rate hikes totaling between 50 and 100 basis points.

At the last FOMC meeting of 2016, the median projection for appropriate policy suggested three rate hikes in 2017, a sentiment echoed by many economists, who note that it will still be a relatively shallow path of increases.

“The way we need to look at this is that this is a sort of path to normalization,” said Mr. Caron of Morgan Stanley (MS). Getting to a pattern of sequential rate hikes can help reduce the volatility of markets, said Mr. Hopper. “You can rely on the fact that the Fed is going to be raising rates. You can plan for that.”

Mr. Friedman of BNP Paribas is calling for just two rate increases in 2017, at least for now. He thinks the FOMC will tolerate some overshoot in inflation and financial conditions will continue to tighten in the coming months, in part if a stronger dollar restrains growth and inflation. And, given the sheer scope of what Republicans are trying to achieve on tax reform, “pro-growth tax policies may also be somewhat slow to materialize,” he noted.

Still, while Federal Reserve Chairwoman Janet Yellen expressed uncertainty over the fiscal policy outlook at the FOMC's last press conference of 2016, she recognized that a few members had begun to reflect their expectations for a stimulus package in their macroeconomic and policy projections, Mr. Friedman noted. “If the Fed sees very, very clearly that fiscal stimulus is coming, they could bring forward rate increases a little bit,” he said.

Interest rate rises could affect defined benefit plan sponsors in several ways.

“At the macro level, rising interest rates are a boon for pensions,” said Matt McDaniel, a partner in Mercer's retirement business, noting that “it's not so much the rising rates themselves, but that things are looking better,” which can mean good news for equity holdings in particular.

It is a different story when it comes to measuring pension liabilities, because sponsors use much longer duration bonds to calculate them, compared to the Federal Reserve's short term bank lending rates. “The actions of the Fed don't have a one-to-one impact on pension fund rates. Pension liabilities have very long tails,” said Mr. McDaniel. Mercer's yield curve index found that in 2016, typical discount rates for pension plans decreased by 20 basis points during 2016 to 4.04%, offsetting gains in equity and fixed income markets and leaving aggregate pension funding levels unchanged from 2015.

Pension fund portfolios with a lot of bonds, particularly longer duration ones, could also see values fall as the yield curve flattens. That makes more plan sponsors embrace LDI, said Mr. McDaniel. And even though pension risk transfer is more expensive when rates are low, “it is mattering less and less,” he said, noting that last year's stagnant interest rate environment did not dissuade many pension sponsors from fully terminating their DB plans or reducing risks.

A LIMRA Secure Retirement Institute sales survey found that U.S. corporate pension plan buyouts reached $5.9 billion in the third quarter of 2016, the largest third-quarter activity since 1990.

Better funding ratios plus equity market gains create more opportunities for risk transfers to lock in gains and reduce volatility of contributions and expense, said Richard McEvoy, partner and head of Mercer's financial strategies group. He cautions plan sponsors to carefully evaluate their next steps, given that Mr. Trump's policies “could create a meaningfully different market environment than investors have faced since the financial crisis.”

Even if rates rise, Mr. McEvoy said, there are benefits to borrowing to fund a defined benefit plan, including deducting the interest, stabilizing payments and reducing variable rate premiums paid to the Pension Benefit Guaranty Corp.

Another wrinkle this year is that the Federal Open Market Committee will have four new voting members this year, thanks to an annual rotation of seats among the 11 regional Federal Reserve Bank presidents. In contrast to the economists who typically fill those seats, three of the four new voting members — Neel Kashkari of Minneapolis, Charles Evans of Chicago and Patrick Harker of Philadelphia — all joined within the past two years and bring varied experience in investment banking, engineering and more. Mr. Kashkari, for example, left Goldman Sachs Group (GS) to oversee the Treasury's Department's $700 billion Troubled Asset Relief Program before joining Pacific Investment Management Co. LLC to build its equity franchise, while Mr. Kaplan, another Goldman Sachs alumnus, joined the board from Harvard Business School.

Mr. Trump will also be filling the two current vacancies for permanent governors, and appointing a chair to replace Ms. Yellen, whose leadership position ends in February 2018.

The surprises awaiting committee members in 2017 will be different than those faced in 2016, said Mr. Kohn of Brookings, but one thing remains the same. They “will test the Fed's ability to adjust policy to changing economic circumstances, and then to explain clearly why it made the decisions it did.”

Myles Clouston, Nasdaq senior director of advisory services, thinks the next few months will be a “wait-and-see period” as things unfold in the U.S. and globally. “There's clearly a lot that's going to affect their ability to raise rates,” said Mr. Clouston, pointing out that rates would have to get to high single digits before they would start to affect the cost of capital.

This article originally appeared in the January 9, 2017 print issue as, "Raft of unknowns make Fed direction tough to predict".