Trump’s Fed-bashing and interest-rate panic will cause a recession, not prevent one

Finance news

President Donald Trump’s tweet on Monday morning admonishing the Federal Reserve for even thinking about raising interest rates amplified his recent criticism of Fed Chair Jerome Powell, and just a day before the Fed begins its two-day Federal Open Market Committee meeting to decide whether to go ahead with another increase.

In a recent interview, Trump said of his own appointee to oversee the Fed, “I’m not even a little bit happy with my selection of Jay. … They’re making a mistake. … My gut tells me more sometimes than anybody else’s brain.”

In October, Trump called the Federal Reserve the “greatest threat” to his presidency. His attacks on the Fed may be a greater threat to the country.

Should Powell simply cave into the political pressures from the White House, it could spell disaster for the U.S. economy. The last time this happened was when Richard Nixon was in office, and what followed was one of the worst economic recessions of the 20thcentury.

Although the call for slowing the pace of interest-rate hikes is not limited to the president, his comments are based on the political calculus of how higher rates are impacting stock prices, the self-proclaimed measure of his administration’s economic success, and not a deeper understanding of the economy or the goals of monetary policy. They do not help the economic policy discourse and may even be dangerous.

With the unemployment rate at 3.7 percent and GDP growing above a 3 percent annual rate in the third quarter of 2018, most economists consider the U.S. economy to be in a situation of “full employment.” Over the past two years, the recovery from the Great Recession has added another 3.8 million jobs on top of the 12 million created over the previous eight years. The Federal Reserve has remained on track toward policy normalization, raising the federal funds rate seven times since December 2016, and there are compelling reasons for why they should continue this policy.

First, the recent acceleration in economic growth and low interest rates has heightened inflation concerns. The current CPI has been increasing at an annual rate of 2.5 percent, the highest in seven years, with both the producer price index and wage growth rising more than expected over the past month. Furthermore, the large corporate tax cuts, a budget deficit expected to exceed $1 trillion and escalating trade wars with China and other trading partners are expected to add to these inflation pressures.

Second, we are approaching the tenth year of economic expansion, currently the second longest in U.S. history, and both the Federal Reserve and bipartisan CBO are forecasting slower domestic and global growth in 2019. The likelihood of a recession occurring within the next two years are rising, with economists at JP Morgan placing the chances as high as 60 percent. Interest rates will need to be in the “neutral” range at that time to give the FOMC enough ammunition to prevent a serious economic downturn. This calls for additional rate hikes over the next year as well as continued unwinding of the Fed’s balance sheet, which grew to $4.5 trillion during the Great Recession. The reverse QE policy will abate concerns of the higher short-term rates leading to an inverted yield curve.

Third, keeping interest rates too low for too long exacerbates the type of excessive risk-taking by financial institutions that led to the financial crisis. The TED interest-rate spread, which is an indicator of credit market risk, has more than doubled in the past two months and is higher than its five-year average. Normalizing interest rates is one of the keys to a stable financial market.

It is without a doubt that prudent monetary policy is the No. 1 reason for the sustained economic growth of the past three decades. An independent and non-political FOMC is essential for the Federal Reserve to achieve their objectives of price stability and maximum employment. The greatest threat to the economy today is not what the Federal Reserve is doing but how it responds to a president with little regard for eroding the public confidence in our government institutions.

Unfortunately, there are indications that Trump’s barrage of attacks on the Fed is having an impact.

In a recent speech to the Economic Club of New York, Chair Powell said that the fed funds rate was “just below” its neutral level and called for a more data-dependent monetary policy, contradicting his previous statement only a month earlier that they were a “long way off” from rate normalization. This should be of concern given that nothing has fundamentally changed over the past month with the exception of elevated stock market volatility. Although monetary policy should be data-dependent, their dependency should be based on rules rather than discretionary actions and presidential tweets.

While the members of the FOMC have always been a mix of doves and hawks who represent a range of opinions, they always have been able to reach a consensus based on sound economic reasoning. There has been no dissenting votes on any of the Fed rate hikes under Powell. Furthermore, the median projection of the fed funds rate in 2019 by FOMC members has remained consistent at above 3 percent, suggesting at least three more hikes over the next year.

Backing off from the current course of policy normalization for a short-term bounce in equity markets would erode Powell’s credibility, cloud Fed transparency and raise inflation expectations. It was widely expected that the FOMC will raise rates for the fourth time this year, a move Trump has called “foolish.”

If the Fed does slow down the pace of rate hikes, they should clearly communicate how economic conditions have changed relative to their previous forecast to support their change in policy.

By Victor Li, professor of economics at the Villanova School of Business. Li worked with former Fed Chairman Ben Bernanke at Princeton University from 1998–2000 and at the Federal Reserve as a visiting scholar at the Federal Reserve Bank of St. Louis. He was a senior economist at the Federal Reserve Bank of Atlanta from 2000–2001.