Monetary and Fiscal Policies -- Some Short- and Longer-Term Considerations

The markets now assign a near-100% probability to a Fed rate hike in December, and this is not likely to change as a result of this week's FOMC Meeting or key US economic data.  Monday's expected low September Core PCE Deflator will just mimic the low Core CPI released a couple of weeks ago.  A number of Fed officials already have dismissed currently low inflation as temporary.  Wednesday's FOMC Statement should retain the important elements of the prior one, which kept open the door to gradual tightening.   Wednesday's October Mfg ISM should be strong, even if it dips as consensus expects.  And, Friday's October Employment will be distorted by a post-hurricane rebound in jobs and slowing in Average Hourly Earnings.  Indeed, the risk is that the +315k consensus estimate of Payrolls is too low and +0.2% m/m consensus estimate of AHE too high.

All the markets -- stocks, Treasuries and dollar -- should continue to be impacted by the possibility of a tax cut being passed in December.  The latter should help sustain the stock market rally and keep upward pressure on Treasury yields and dollar.  While stocks could begin the coming week on a cautious note, ahead of earnings reports and the FOMC Statement, they should bounce back in the second half of the week.  Note that Fed Governor Powell, the apparent front-runner for the next Fed Chair, speaks on Thursday.  He is not likely to deviate from the official Fed line, namely that the economy is strong, inflation is expected to pick up, and policy is on gradual tightening path.

From a longer perspective, a tax cut ironically could be the biggest threat to the continuation of the US economic expansion.   A tax cut would push H118 economic growth above the current, already strong 3% pace.  But, this boost would be temporary, as Fed and market actions work against the impact of the tax cut on the economy, particularly if inflation speeds up as a result of the stronger economy.  To be sure, stocks should rally in anticipation of and for a while after the tax cut is passed, but the rally would likely stall at some point in H118 on the legitimate fears that the Fed will accelerate its tightening plans.  These fears also would drive up the dollar and Treasury yields, with the 10-year yield probably exceeding 3%.  The restraint from Fed tightening, higher Treasury yields and stronger dollar will build over time, hitting the economy in H218 or H119, just at the time the thrust from the tax cut begins to abate.  While the result may be just a sharp slowdown in US economic growth, the risk is that it could slip into recession.