Trump vs Powell: Who is right about the economy?
The Powell-led Federal Open Market Committee (FOMC) raised the benchmark interest rate to a target of 2.25 - 2.5 percent this month, marking the fourth hike for the year while communicating plans to slow down future interest rate increases in its effort to keep its mandate in stabilizing the economy through both interest rate policy and forward guidance.
This action has been strongly criticized by President Trump, who has tweeted that the he believes this move is wrong, much like he also said earlier interest rate hikes were also ill-timed. The President has even gone further to say that the problem with the economy is the Fed (the Federal Reserve System) and this has put Powell as the Fed Chair in the President's political crosshairs.
So on the assumption that both Trump as the POTUS and Jerome Powell, as Fed Chair, want what is best for the economy, who might one surmise to be correct on monetary policy? Of course one might be quick to suggest that it should be the economists and policymakers who actually carry out a highly informed vote based on sound economic data and analysis, within the FOMC. However let me hold off on that briefly and sort of take an objective look at things, perhaps we may find that the Fed was not correct, who knows? After all there are a nontrivial number of economists who argue that the Great Depression and possibly even most or all of the recessions we have faced since then could be traced to the Fed as the culprit behind those through what they believe to be incorrect policies.
Mainstream economics has long embraced the Keynesian perspective that discretionary monetary policy can be useful in stabilizing the economy. Even the ardent monetarist and Nobel prize winning economist, the late Milton Friedman, who believed that while monetary policy was important it should be based on clear rules not discretion, has been quoted as having once said, perhaps tongue in cheek, that "we are all Keynesians now".
While of course a lot has happened since the 1940s Keynesian wave, and Keynesian theories have been smothered and resuscitated, especially on the fiscal side of things, monetary policy has largely been accepted sort of within the new neoclassical economic synthesis of the 1990s which continues to guide modern economic analysis. So generally speaking, monetary policy is considered useful in economic stabilization.
So what does monetary policy call for presently? We are currently experiencing an economic boom with unemployment rate of 3.7% at 50 plus year lows, and falling well below the estimates of the natural rate of employment. This means effectively that production is currently exceeding its capacity. Businesses are having to produce more output only by raising wages to reward overtime effort, or and by bidding workers away from other jobs. It has been documented in the news how in the past couple years the hiring process has become slack with respect to background checks and drug testing as businesses look to hire workers at all costs.
The data on wages have shown wage growth. Wages increased 3.1% for the month of November, which followed a similar increase for the month of October, and CPI data for the month of November shows an increase in prices of 2.2% from last November.
The Fed therefore believes that inflation could be a concern and, as expected, in such a situation will set a higher interest rate target for the benchmark interest rate, which in turn will make it costly for banks to borrow and therefore make it costly for everyone else to access loans for all forms of credit based spending. This would result in reduced spending and a downward pressure on prices.
The main problem with these interest rate hikes apparently from the perspective of President Trump is the assumed effect on the stock market. With each interest rate hike the market seems to sell off, so stocks fall, and the specter of a looming recession is waived by the media and some pundits.
Trump obviously wants the best of all worlds: low unemployment rates, continued economic growth, and a booming stock market... and no inflation. All of which point to a strong economy, one that can be politically attributed to the policies put in place by the incumbent administration. Quite naturally falling stock prices is bad as it can only be traceable to the current administration as well, so the President has to be quick to make it clear that the recent hiccup in stock prices is due to the Fed's interest rate hike, a decision outside the purview of, and against the "better" judgment and advise of the administration.
This is important because appearances are everything. The public is rationally ignorant about fundamental economic relationships and even the most astute of institutional investors are driven by animal spirits when it comes to financial investment choices. No one wants to lose millions of dollars on the premise that they believed market fundamentals are good when they see all around them people frantically selling.
Further, even individuals that have little or no financial investments in stocks react pessimistically when all they hear across all media outlets are that stock prices have fallen and pundits keep bringing up the 'R' word. So if the economy tanks the question everyone asks is, on whose watch did this happen? 'Its the economy stupid', comes very quickly to every politician's mind and so who is to blame has to be very clear.
The issue at stake though is perhaps not so much that the President wants rates to remain low regardless of inflation (at least I would think that is the case), but rather that the Fed is not having the correct pulse on the economy and is therefore acting hastily and prematurely in raising interest rates.
This argument could have some merit, after all monetary policy is still a balancing act that involves consideration of many parts of the economic puzzle, some which are a part of the sophisticated models employed by Fed analysts and some perhaps which are omitted or difficult to quantify and add to these models.
A cue from some of the comments made by the President may provide some of that information: he talked about the Fed not seeming to take into consideration his tariff policies, and the already relatively slower pace in market activities compared to earlier on in the year. So how important are these, and how should they influence monetary policy?
Well, first of all, it is theoretically feasible to argue that part of the inflationary pressures could be attributable to the tariff policies. One reason behind GM's shocking action last month in a decision to close some of its plants in North America and lay of about 14,000 workers was the higher costs of production due to the steel and aluminum tariffs. As I have discussed in a number of earlier blogs, these tariffs do spread to raising both production costs for those US producers who relied on the cheaper imports in their production, and consumer prices, as attempts are made to pass on the higher production costs in the form of higher prices on the finished products that use those as inputs. So while the tariff policies may be generating supply side inflation, the Fed may be seeing inflation more generally and perhaps and therefore the need to raise interest rates than otherwise.
It is known that a supply side driven inflation that is tackled with a demand side policy could lead to an economic slowdown, but it just might be the price that has to be paid to perhaps kill off what may be a worse outcome since the economy eventually readjusts back, but prices remain at their new lower level. A case in history is the 1980s Volcker disinflation. The proper question to ask perhaps is why the tariff policies in the first place?
What about the relatively slower pace in market activities? Perhaps here we might be barking up the wrong tree. Is it prudent policy to feed a beast? The markets have been used to cheap credit. Both the urgency of action needed to fight the Great Recession and the continued need to prop up a weak recovery led to years of flooding financial markets with money. Quite naturally it led to the boom we are now experiencing and with it possibly a stock market bubble. In an environment where excessive risk taking could thrive, regulation is called for, especially because losses from such risky behavior tend to be systemic and not isolated. But what has the current administration done? It has sought to undo the much needed regulation that should prevent another financial crisis, and now as the markets experience these very sharp drops from artificially induced high levels the blame is put on Fed policy. Should the Fed be complicit in the generation of a political business cycle by continuing to indulge the risk loving appetites prevalent within the financial market?
A bubble will definitely go bust at some point, but the bigger will be the damage the greater it is artificially induced and encouraged, and then the policy that should be used to fix the problem will appear to be ineffective since it was the exact same policy that fueled the problem. It is unnatural policy for interest rates to be kept low when the economy is experiencing a boom with unemployment well below the natural rate. It is more a failure of Administration inspired regulatory policy than it is of independent Fed monetary policy when the volatility in the stock market is severe and persistent.
At stake now is the assumed independence of the Fed in the conduct of monetary policy. I surmised in a much earlier blog that the dovish stance of the Fed earlier in the year might be attributable to political influence - Trump appointed Powell as chair of the Fed and the slow action to raise interest rates may have been because of the known preference of Trump for lower interest rates. It is possible that even that delay could be to blame for the eventual overreaction by the markets, when rates were raised in June and later in September. The current media frenzy relating to plans that Trump intends to fire Powell could be a veiled threat that ensures that Powell does not defect from the implied forward guidance provided on slowing down future rate hikes, such hikes which I believe to still be warranted.
The Fed's latest decision to raise interest rates is spot on, and the President's position is apparently politically driven. A coalition of particular constituents is deemed to be representative within particular states to deliver reelection: these would include those apparently helped by the tariffs and related trade policy "wins" (largely farmers, companies doing business in China, US steel industry etc.), institutional investors and generally those with large holdings of stocks. Finally those who can be persuaded by perceptions of wage growth (provided the numbers continue to support this and there is no bad news elsewhere - like stock market drops) regardless of what is actually happening to real wages (the inflation adjusted wage growth). This is a political economy perspective and is not bashing the administration. It is good politics.
What is however genuinely good for the economy given the numbers and the realities about financial markets is for the Fed to genuinely watch for inflation cues and to raise interest rates if it sees that this continues to look like a problem, and importantly that they do not wait for a financial crisis to erupt before taking action, given the current stock market outlook that looks very much like a bubble. Tighter financial market regulation is needed though I will add that introducing this now rather than previously could also spook the market, but it might be best now rather than after the fact. Unfortunately the political will to do these things is usually very weak until after the fact.