THE FED VERSUS TAX CUTS / THE WALL STREET JOURNAL

The Fed Versus Tax Cuts

The central bank has pushed back against tax cuts in recent years by raising rates

By Justin Lahart


Federal Reserve Chair nominee Jerome Powell testifies before the Senate Banking Committee last month. Photo: Ron Sachs/Zuma Press


The Republican tax plan has been driving the market. The Federal Reserve could be next behind the Wheel.

The tax plan’s final details are still in flux, but whatever form it takes, two things are clear.

First, the expected corporate tax cut will boost corporate earnings. Second, it should give some sort of boost to the economy next year. Both those things seem pretty sweet to investors, which is the big reason why stocks have performed so well as the tax plan moved from “maybe” to “almost certainly.”

The Fed also has grown more certain about the future. It is on track to raise interest rates for a third time this year on Wednesday, and it expects to keep raising rates next year. Experience with tax cuts suggests that investors should be watching the Fed as carefully as they watch the markets.

According to a recent Fed working paper, tax cuts have tended to act as a drag on stock-market returns since the 1980s. Starting then, the authors say, the Fed got a lot more vigilant about responding to inflationary pressures. So before the economic effects of a tax cut had a real chance to show up in corporate cash flows, rates already were getting wrenched higher. Before the 1980s, the Fed was slower to respond to tax cuts, in part because it showed less political independence, so tax cuts were better for stocks.

THE FED HAS BEEN ITS FRIEND
The S&P 500

Today, the Fed values its independence far more than it did in the 1970s, and that appears to be true for incoming Fed chair Jerome Powell. Still, persistently low inflation might keep the Fed from aggressively raising rates. Yet with unemployment low, it wouldn’t take much of a pickup in either inflation or wages for the Fed to try to offset the stimulus of tax cuts by raising rates.

High stock valuations have been a concern for some Fed officials for a while now, and the market rally in anticipation of tax cuts is probably adding to their unease. Tax cuts have driven the market higher, the Fed may determine their next move.