US + Brazil Financial News (11/06)

Fiscal policy is the wild card in macroeconomic management, usually, badly played. The current tax cut proposal is an example. Admittedly, what the House is likely to pass this week will change in the Senate. That will be the proposal that counts. And, as with all tax legislation, “the devil is in the details”. Even so, on the corporate tax side, the broad outline of the bill, which analysts say has a 2/3 probability of becoming law, is clear: Lower corporate taxes; pro-investment changes in the rules for capital depreciation; incentives for the repatriation of profits held abroad by US corporations; limits to interest deductibility (that biases the capital structure of firms towards debt over equity financing); elimination of tax privileges targeted to specific activities or groups (that bias the allocation of capital). These items of the proposal are also those with broader bi-partisan support, and with broad consensus among economists and tax specialists. Over the long run, and absent countervailing effects, they should lead to increases in competitiveness and productivity, boosting future output, employment and real incomes. From a timing perspective, however, the proposal—that would have been welcome in 2008/2009—may be ill-timed a decade later.

Today, the economy is at full employment, operating at near-or-full-capacity. Last week’s data showed that the US labor market continues to tighten. Cutting through the month-to-month noise, the trend so far in 2017 is that employment is growing in the 150-200k range, well above the roughly 100k breakeven rate to keep the unemployment rate stable over time. The unemployment rate is down to 4.1%, its lowest reading since December 2000, and moving down—further into inflation acceleration territory. Yes, the controversy over low inflation remains, as does that about wages. However, in both fronts, there is more than meets the eye—and the Fed is aware. Composite wage trackers —which summarizes different indicators weighted by their statistical information content about the underlying wage trend—show wage inflation approaching 3%yoy—and the sustainable pace of wage growth is now considerably lower than in prior cycles because of the sharp slowdown in productivity growth.

For the first time since the crisis, there is a coordinated global expansion, and the acceleration in economic activity since early 2016 mirrors the sharp easing in financial conditions. The Fed, and other G4 central banks, think that tighter labor markets and higher capacity will engender higher prices. The market does not. As a result, there is a flattening of the yield curve with gaping divergences in future rate expectations between policy and market makers. But, in the end, the market adjusts to reality, thus to policy. The indication of Jerome Powell to be the next Fed chair is a sign of continuity in monetary policy. The sequence remains, with high probability: a hike in December followed by 3-4 subsequent hikes in 2018. Of import, the logic remains: A Fed that, with an economy at full employment, will—and should—act to neutralize the demand-side impacts from changes in the tax legislation. Powell may favor deregulation. However, by his own admission, he also favors following indicators of financial conditions (FCIs) in monetary policy decisions. Hence, what may move in one direction could be neutralized, at least in the short run, with tighter policy.

Which leaves us with speculation about the supply side effects of the legislation—a very controversial topic. In the Fed models, the short-run supply side impact of the proposed legislation would be small and heavily dependent on what happens to consumption, thus to the income, not corporate tax. (Note that, in the short-run, CAPEX increases spending, not supply.) What will happen ultimately to the income tax is the least clear of all. If, in the Senate, current legislation holds, the tax bill should comply with the rule of revenue-and-deficit neutrality, beyond 10 years. A good rule. Thus, the overall take from the income tax may have to increase, to compensate cuts in the corporate tax. A very complicated proposition.

There are no first-order data releases this week. Of interest will be the JOLTS report on labor markets, an indicator closely followed by Janet Yellen, by her own account. On Friday, the preliminary U-Mich consumer sentiment. Perhaps of greater market relevance, will be Fedspeak: Dailey on “Lessons from the Financial Crisis”; Quarles on financial regulation; Yellen on ethics. The senior loan officer opinion survey is out today.

Last week’s COPOM minutes confirmed the message. The cycle of rate cuts is at near-end, with a likely deceleration in the pace to 50bp at the next meeting, in December. Paragraph 24, meanwhile, could not have been more explicit: What happens after that is uncertain. For the time being, we maintain our expectation: This will be the final cut of the cycle, bringing the Selic rate to 7%pa. The rate will transverse unchanged an expectedly turbulent, politically, 2018. The data on the fiscal side was also as expected, if not slightly better. The primary deficit dropped 0.1pp of GDP to 2.4% on the 12 months accumulated to September. The deficit is now in line to meet its target for 2017, set also at 2.4% of GDP (R$162bn). Finally, sealing the good news, the committee that dates business cycles, CODACE, marked officially the end of the recession, in Q4/2016. The last recession lasted 11 quarters with an accumulated drop in real GDP of 8.6%.

There are few relevant indicators this week. Of note, October IPCA (CPI) inflation.