The Fed gave markets what they wanted and traders celebrated. Whether it is behind the curve or not, a 50-basis point cut in the Fed Funds rate was a right initial step in a series of rate cuts to come. The key question was never whether 50 or 25 basis points was the right way to start. It’s where does the Fed end the rate reduction process? That will depend on two factors. First, what is the path of the economy over the next 12-18 months? If we are going to have a soft landing and eventually return to normalized growth, then the cuts will be gradual and the point will likely be somewhere north of 3%, as the dot plots from last week’s meeting indicate. If a recession ensues in the interim, rate cuts will be steeper and the end point will be less than 3%.
The second factor, really a question, is what is the neutral rate, the rate that neither stimulates nor retards the natural growth path of the economy? Economists have been debating that for years without reaching any consensus. Some suggest the neutral rate moves around due to other factors. For instance, an excessive number of outstanding low interest mortgages may require additional cuts to stir the proper level of housing activity. But one thing is certain, at least in my mind. The neutral rate cannot be below the long-term rate of inflation. There must be a real cost to money, otherwise, monetary policy creates unwanted distortions. The distortions in the housing market today, for instance, are clearly the result of an excessive period of low interest rates that put the cost of a mortgage substantially below the rate of inflation for an extended period of time. Not only did first time buyers take advantage, but existing mortgage holders refinanced. That has left the housing market with an inadequate supply of homes for sale and inflated prices that deter buyers.
Kamala Harris has an answer, a large tax credit for first time home buyers. To be sure, changes in tax laws modify behavior. A large credit will clearly increase demand for homes by lowering the effective cost. But is this a good answer? Politically, it scores points in an election year among those looking to buy a first home. But economically, it raises demand for homes at a time when the biggest remaining inflationary pressure is the cost of housing.
Put two identical homes side by side. One is available for sale; the other available for rent. The suggested tax credit skews the decision in favor of purchase. Is owning a home better than renting an identical home? As Geoge W. Bush noted two decades ago, owning a home is the American dream. That dream ended up creating a financial crisis and mass foreclosures. Would this time rhyme? If Freddie Mac starts issuing second mortgages, and other non-bank lenders offer foolish incentives, it could. Unlikely, but possible. My point is that election year promises are often enticing on the surface but fail to pass muster when examined carefully.
I don’t mean to pick on VP Harris. I could mention tax-free tip wages, tax-free Social Security benefits, 10% caps on credit card interest rates, and tax-free overtime pay to the list. Tax-free tips would entice more compensation via tips and, since many tips are paid in cash, such a proposal would result is a serious reduction in tax collections. A 10% cap on credit card interest rates would sharply reduce the number of Americans eligible for credit cards and almost certainly reduce the grace period from 30 days to a much smaller number.
All these “promises” from both sides, are simply an attempt to entice voters. On the surface, they work. Why else would candidates make such suggestions? I have no clue whether these enticements will swing the election outcome. After all, both sides make their own set of promises that will never become legislated. But from an economic or investment perspective, each should be looked at very skeptically, unlikely to become law.
We are six weeks out from the election and not only is the Presidential race too close to call, but control of both chambers of Congress remains in doubt. Section 7 of our Constitution starts by saying “All bills for raising revenue shall originate in the House of Representatives”. While the majority party will control leadership of the Ways and Means Committee, as we have seen over the past two years when Republicans have had a slim majority, finding almost complete consensus within either party has been elusive.
But that will have to change in 2025. Because the Trump tax cuts of 2017 expire at the end of 2025. Letting them expire means the standard deduction gets cut by more than 50%. Today, almost 90% of taxpayers use it versus 70% in 2016. Letting them expire means the top marginal tax rate goes back to 39.6%. That impacts not just the upper class but families making more than $137,000. Didn’t Biden/Harris say no tax increase for those making more than $400,000. What happened to George H.W. Bush in his reelection bid after saying “Read my lips. No new taxes”? There are lots of other items to be renegotiated including the SALT deduction, estate tax exemptions, and the possible return of the alternative minimum tax.
I get that no one wants to talk about this. For one, talking about taxes in an election season isn’t particularly popular. Second, the debate is too arcane and difficult for most voters to conceptualize. But my points are that in 2025 no subject will be more important than taxes, and the problem can only be solved by compromise. In addition, since both Harris and Trump clearly want to spend more than they take in, tax legislation has to be scored by the Congressional Budget Office. That may not matter to the average American but it will matter to many legislators. The reason many tax laws have sunset provisions is that allowing the goodies to last forever is too expensive.
As for the campaign itself, the race remains too close to call as noted. What can change that? The two top issues, according to polling, are the economy and inflation. Both favor Republicans. If Trump could stay on message, it would be to his advantage. As for Harris, the enthusiastic honeymoon is over. Just saying she will lift the middle class isn’t enough. It’s time to put some meat back on the bone. Her avoidance of details stem, at least in my mind, from one or two causes. Either she hasn’t flushed out the details to the point where she can outline them. Or, she thinks that presenting the details will cost her votes. Her dilemma is that undecided voters are thirsty to hear more. She is clearly more liberal than some would like. It may be comforting enough that Congress won’t give her all she wants but is that enough to get swing voters to vote in her favor?
Thus, Trump needs to stay on message more and Harris needs to flush out her intentions in greater detail. The one who does a better job is likely to be elected. From an investor’s viewpoint, who wins may not matter as much as it appears during a campaign. The keys for 2025 are going to be the path of interest rates, and that’s in the Fed’s hands, and what legislation will emanate from the expiration of the tax cuts.
To put an exclamation point on the difficulty of achieving legislative compromise, the Federal government will partially shutdown if Congress can’t pass bills that fund the government past September 30. As noted earlier, such legislation starts in the House and there Republicans, so far, can’t get enough votes themselves to pass the necessary bills for reasons that get into voting politics, not economics. To date, Speaker Johnson has had to compromise with the Democrat minority to get anything done. He will have to do so again this time. Maybe that offers some positive hope that a year from now, a tax compromise will be in the works.
We’ll be watching.
While I usually list several birthdays to end my notes, today there will be only one. The Boss. Bruce Springsteen turns 75 today.
James M. Meyer, CFA 610-260-2220