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Why the US may be headed for multiple interest rate hikes

Every December,  the Federal Reserve finds the courage to raise interest rates. At least that has been the case for the last two years. The latest move, another minimal one-quarter percentage point hike, showed that this merry band of central bankers is quite passive in its approach to monetary policy.

But this could change quickly. If Congress passes much of Donald Trump's economic stimulus plan, we could be in for a lot more rate hikes next year than anyone expects.

First, why did the Fed act?  Normally, a rate hike occurs when the economy is growing too fast or inflation is too high and the monetary authorities need to cool things off.

But that is hardly the case now. Yes, the 3.2 percent increase in GDP during the summer was solid, but the economy will expand by less than 2 percent this year, which is pretty mediocre.

As for inflation, it is still below the Fed's 2 percent target.  It may be accelerating, but it is doing so only slowly.

The Fed raised rates because it needs to "normalize" the level of interest rates.  Even after the hike, rates remain at historically low levels. While economists differ as to what is "normal," the estimates are generally in the 3 to 3.5 percent range.  Given the current rate is about 0.6 percent, the Fed has a lot of work to do to get back to normal.

And getting back to normal is necessary. The expansion is in its eighth year and that means it is getting old.  Cutting interest rates is a key tool in the Fed's arsenal to deal with an economic slowdown.  Unless rates rise significantly, the Fed could be fighting the next economic war without its prime weapon.

So, this was not a move to slow the economy but an attempt to position itself so it can deal with a future economic downturn.

That said, an increase in rates could also be considered an insurance policy.

The missing link in this expansion has been fiscal stimulus.  Indeed, over the last six years, cutbacks in government activity have actually slowed growth by an average of 0.2 percentage points each year.

That may not sound like much, but during the last six years of the Reagan administration, when the economy grew at a 3.5 percent pace, government spending added 0.8 percentage point to growth.

Had fiscal policy been the same during the Obama years as it was during the Reagan years, the economy would have expanded about one percentage point, or nearly 50 percent, faster than it actually did. And that doesn't include the impact that growing government spending would have had on the rest of the economy, the so-called multiplier effect.

If Trump's fiscal policies are implemented, growth could increase to a very solid 2.5 to 3 percent pace. But no good economy goes unpunished. With the labor markets near or at full employment and wage gains already accelerating, firms will likely have to raise prices faster to offset the increasing costs.  That could drive inflation well above the Fed's target.

When you factor in the rising price of energy, which will now add to rather than subtract from inflation, it is highly likely that inflation will move up sharply over the next year.

The prospect that inflation will jump is another factor in the Fed's decision to start the process of normalization now.  The economy is currently growing at a pace modest enough that firms don't have to raise wages rapidly.  But with expansionary fiscal policy once again on the table in Washington, better economic growth and higher inflation look to be in our future.

The Fed members don't want to be forced in the future to raise rates rapidly in order to slow inflation.  By modestly increasing rates, the Fed may not have to jam on the brakes, which in the past has pushed the economy into recession.

Fed Chair Janet Yellen has indicated that when the uncertainty over fiscal policy is clarified, the monetary authorities will react accordingly.  If we do get anything close to the stimulus that Trump has proposed, the Federal Reserve's reserved approach to interest rate hikes may change quickly.

The strategy of one rate hike a year looks as if it is over, to be replaced with multiple increases. If inflation accelerates as much as I expect, we could see three or four increases next year and even more in 2018.

So buckle up, the times they are a-changin'.