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– December 16, 2014

In December 2008, the Fed set its benchmark short-term interest rate to a “zero lower bound,” its lowest level ever. Now, amid a continuing expansion, the Fed has suggested a rate rise may come as early as the middle of 2015. It would be the first hike in the federal funds rate since mid-2006.

The effects of ending such an unprecedented period of low rates may depend on how quickly increases take place, given the uncertainty surrounding the strength of economic growth. The pacing of interest rate hikes will likely be a critical element in determining financial market reactions as well.

In the last rate-hike cycle (2004-2006), the fed funds target rate rose by 0.25 percentage points with each Federal Open Market Committee (FOMC) meeting over a two-year period until it reached 5.25 percent in June 2006. We cannot be sure of the pace this time, given the influences affecting the current economic environment. In addition to starting from a record low rate, there is the disparate performance in the world’s major economies and a still soft U.S. labor market. It is not out of the realm of possibility that rate increases this time around will occur more gradually, say at every other or every third FOMC meeting. And, should the U.S. expansion lose momentum, further hikes could be postponed.

As the American economy struggled to recover from the financial crisis and recession, the Fed stepped in to support growth through its quantitative easing policy of large-scale asset purchases. This form of monetary easing produced a sizable increase in holdings on the central bank’s balance sheet. In October, the Fed ended the policy. Now with a probable rate rise drawing closer, we look to whether the Fed will also cease its policy of rolling over the securities it holds – known as balance sheet reinvestment – or if it will begin shrinking its holdings by not reinvesting those assets when they mature.


November’s mid-term elections changed the balance of power in the U.S. Congress. When the new legislative session convenes in January, Republicans will run the Senate as well as the House of Representatives. However, Republicans, who will hold 54 seats in the upper chamber, would need at least a few others to reach the 60 votes needed to end a filibuster or override a presidential veto. Nonetheless, Republicans are likely to reshape the nation’s fiscal priorities.

Curbing the budget deficit has been an important priority for Republicans for years. Their emphasis on cutting spending while reducing taxes has fueled repeated battles, created the “fiscal cliff” in 2011, and led to a government shutdown in 2013.

Yet amid economic expansion in recent years, the deficit has shrunk considerably (Chart 2). At the depth of the Great Recession in 2009, it reached 9.8 percent of GDP. By last year, the deficit had narrowed to 4 percent of GDP. The Congressional Budget Office projects further shrinkage into next year, ultimately reaching the long-term average of 2.8 percent of GDP. In this environment, the sense of urgency over deficit reduction has subsided.

Still, Republicans’ control of Congress can be expected to alter government’s spending priorities. One likely area of change is defense spending. The Pentagon’s outlays have fallen in the past two years by a total of about 10 percent mainly because of the automatic spending cuts known as sequestration that began in early 2013. Most Republicans opposed these cuts. A bipartisan National Defense Panel, in a report issued in July, argued that inadequate funding threatens U.S. military capabilities. In a world of rising geopolitical tensions and instability, an argument for greater defense spending may win broad support in Congress.

A significant increase in military spending would have a noticeable effect on the wider economy. Any hike in government spending, if it is not accompanied by a corresponding increase in tax revenue, stimulates aggregate demand and thus promotes growth. If military spending were restored to a pre-sequestration level, it would rise to 4 percent of GDP, from about 3.5 percent currently. Such a bump in federal spending would likely provide a boost to economic growth though it would also widen the budget deficit.

Republicans have campaigned against the Patient Protection and Affordable Care Act (ACA) of 2010, the president’s signature legislative achievement. The Republican-led House has voted, in the past, to repeal the measure. The repeal never went into effect because the Senate, controlled by Democrats, never took up the issue. Next year, Republicans will hold the majority in the Senate as well as the House. Nevertheless, since most of the law has been implemented, to the benefit of many constituent groups, an outright repeal by the new Congress seems unlikely. But changes to various provisions of the law are possible.

For example, a 2.3 percent excise tax on medical devices that took effect in January 2013 has drawn substantial criticism. It is opposed by Republican leaders in both the House and Senate as well as medical device makers. Bills have been introduced in both chambers to repeal the tax. By itself, a rollback is unlikely to significantly affect the broader economy given that tax is fairly small. Yet giving relief to one group could spur lobbying efforts to repeal other measures introduced in the law. Affected organizations such as hospitals, home-health agencies, labs, insurers and drug companies may press lawmakers harder for similar treatment should the burden be eased for device makers. And they may find more sympathetic ears with Republicans in charge. A trend of piecemeal rollbacks would threaten to unravel the ACA, which seeks to balance added costs with expanded sources of revenue.

Democrats as well as Republicans recognize the need for wider tax reform, encompassing both corporate and personal income taxes. A good economic case can be made that simplifying U.S. tax law would improve efficiency and bring other benefits to the economy. But expecting a wide-reaching overhaul next year is optimistic at best when it comes to such a contentious issue, particularly in a year when prospective presidential candidates will be shaping their 2016 political plans. Yet that political maneuvering will almost certainly affect the way Republican leaders of the new Congress shape fiscal policy.

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