As Trump stimulus fades, Fed sees tight monetary policy on the horizon

By Howard Schneider and Ann Saphir

WASHINGTON/SAN FRANCISCO (Reuters) - The Trump administration's punchbowl of tax cuts and government spending may leave the U.S. economy with a stinging hangover in two years, according to fresh Federal Reserve forecasts that show monetary policy moving into "restrictive" territory for the first time in more than a decade.

The new round of projections by policymakers, issued on Wednesday, was the clearest indication yet that higher short-term growth coming from massive fiscal stimulus may pose a cost down the road in the form of interest rates high enough to actually put the brakes on the economy.

A starkly different view has predominated since the 2007-2009 financial crisis. The Fed has focused for the past decade on how much accommodation to provide, in hopes of easing the economy into a steady groove of full employment and low inflation.

In the Fed's latest projections, however, the effect of the administration's tax and spending plan seems to diminish hopes for such a soft landing.

The Fed expects the fiscal stimulus to boost economic growth for two years, but give no apparent permanent help to the economy. Unemployment dives, inflation rises just above the Fed's target, and the central bank responds with interest rates rising to 3.5 percent in 2020, a full half a percentage point above the current estimate of "neutral."

After an extended period of cheap borrowing costs, that rate could be "a lot more damaging to consumer and business sentiment," than similar rate levels in the past, said Scott Anderson, chief economist for Bank of the West in San Francisco.

The policy forecast for 2019 and 2020 seems "like a lot of rate hikes and it does raise the risk that the Fed overshoots and triggers a downturn," he said.

FROM 'MODESTLY RESTRICTIVE' TO LEANING IN

Fed chairman Jerome Powell in his press conference termed that policy path "modestly" restrictive, but emphasized it was a median of forecasts by individuals, not a formal projection by the central bank. In addition, it is "years in the future, it is highly uncertain," he said. "I would not put a lot into that."

Still, the fresh "dots" and economic forecasts issued by the Fed did start to hint at conclusions at the central bank about the combined impact of President Donald Trump's economic initiatives to date.

Powell and his colleagues see the fiscal stimulus pressing unemployment to boomtime lows of 3.6 percent, and appear ready to let that happen without fear of inflation rising too fast.

But the effects fade, and long-term growth falls to around 1.8 percent annually, far from the 3 percent Trump has pledged his tax and spending plans would produce.

There is "higher growth over the next year or two as a result of fiscal stimulus, not as a result of structural factors, such as a permanent improvement in productivity," Cornerstone Macro analyst Roberto Perli wrote.

The Fed's response will not necessarily trigger a recession. But it does indicate that Trump's plans will exact a cost.

"It is a realistic path for rates," said Nathan Sheets, chief economist at PGIM Fixed Income in Newark New Jersey. "I have never seen a hiking cycle by a central bank that in the process of that hiking didn't overshoot."

(Reporting by Howard Schneider; Editing by David Gregorio)