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Why Donald Trump is going to need Janet Yellen

Federal Reserve Board chair Janet Yellen testifies before a Congressional Joint Economic hearing on Capitol Hill in Washington, DC, U.S. November 17, 2016.
Gary Cameron | Reuters
Federal Reserve Board chair Janet Yellen testifies before a Congressional Joint Economic hearing on Capitol Hill in Washington, DC, U.S. November 17, 2016.

After spending a good portion of his campaign bashing Fed Chair Janet Yellen, President-elect Donald Trump is about to find out he will need her if he wants to implement key parts of his ambitious domestic spending agenda.

In her own way, Yellen already has signed on to a key aspect of Trump's plan. During a closely watched speech she delivered in October — nearly a month before Trump won the election — the central bank chief entertained the idea of allowing a "high-pressure economy" to come into existence before tightening the monetary screws.

While the details aren't clear, Yellen said that would entail "robust aggregate demand and a tight labor market" that she said would combat the low-growth environment that has plagued the U.S. since the Great Recession ended.

On the other side of the table is Trump, who is calling for $1 trillion in improvements to the nation's battered highways, public buildings, utilities and other infrastructure. Spending that kind of money likely will require borrowing, which in turn needs the kind of low interest rates the Fed can manage through monetary policy.

During the campaign, Trump told CNBC that Yellen should be "ashamed" of the way she has led policy during a term that began in 2014. Yellen has spoken publicly once since the election, at a congressional hearing, but she gave little indication of how she feels about the incoming administration.

Once he takes office, Trump may end up singing a different tune from his sharp campaign-trail criticism.

"What would be extremely helpful to the economy as a whole would be for the Fed to recognize the fiscal approach of the new administration and be able to foster that," said Alan Rechtschaffen, financial adviser at UBS Wealth Management Americas. "Janet Yellen's speech where she talks about a high-pressure economy gives us an indication or a window into her desire to do that."

Yellen and predecessor Ben Bernanke guided the Fed through a post-recession period of historically low rates in an effort to spur growth. Trump accused Yellen of using policy to boost the fortunes of outgoing President Barack Obama, though Yellen and other Fed officials have steadfastly denied that politics plays a role in their decision-making.

The Fed now finds itself looking to normalize rates. Market participants are assigning a near-100 percent chance of a rate hike at the Dec. 13-14 Federal Open Market Committee meeting. Current indications are that two more hikes are on the way in 2017, then three in 2018.

However, just because the Fed raises its short-term rate would not necessarily mean that government borrowing costs will soar. The central bank currently has a policy of reinvesting proceeds from bonds in its $4.5 trillion portfolio, with much of the money going into longer-dated debt.

Rechtschaffen said if the Fed adopts a two-pronged strategy of reinvesting bond proceeds and jawboning down inflation expectations, that will help the Trump White House fund its programs.

"The No. 1 tool the Fed has always had is to manage inflation expectations," he said. "If they can do that in a way that tempers the enthusiasm somewhat, the president can accomplish many of his goals of funding a fiscal program — a balancing act that could be extremely successful."

Getting productivity in gear

Of course, there's a bumpy road to chart between a moribund U.S. growth picture and Yellen's "high-pressure economy."

One obstacle she has consistently cited is the low productivity growth the country has seen for much of the 21st century. That's resulted in not only low levels of GDP growth but also a cap on earnings for U.S. workers, whose inflation-adjusted paychecks have been flat for years.

"If you have an economy that's being reflated but productivity hasn't picked up, then all of the stimulus that comes from the fiscal side is negated by rates moving higher," said Quincy Krosby, market strategist at Prudential Financial. "What you want to see is real growth. You want to see productivity picking up, because that's the basis of growth."

The good news is that the Organization for Economic Cooperation and Development on Monday raised its forecast for U.S. growth to 2.3 percent in 2017 and 3 percent in 2018, gains the organization said would be realized in part by the new administration's plans for fiscal stimulus.

Also, wages are on the uptick. The Labor Department on Friday is expected to report a 2.8 percent annualized increase in average weekly wages; the Atlanta Fed's measure is even higher, with wage-growth at 3.9 percent in October, the highest pace in eight years.

A jump-start from the fiscal side could add a little fire to the trend and even inspire some economic risk-taking, to add to all the risk-taking in financial markets during the ultra-easy course of post-recession Fed policy.

"One thing that's been AWOL the entire recovery ... has been animal spirit behaviors, and I think that has a lot to do with lack of confidence in the future, and that has a lot to do with the deflationary abyss," said Jim Paulsen, chief investment strategist at Wells Capital Management. "That could be coupled with some behaviors that we just haven't seen that could really bring a good feel to the whole thing for a while."