Fed Independence: Collateral Damage in the Trade War
In a few days, the FOMC will meet and decide what US monetary policy will be going forward. Although the economy remains strong by many metrics — unemployment rate of 3.7%, GDP growth of 3.1% Y0Y in the first quarter, and consecutive months of rising retail sales — traders have fully priced in a 25 bps cut in the federal funds rate come end of July. Some have even priced in a 50 bps cut, a bold bet given the economic data we have currently.
Boston Fed President Eric Rosengren noted that preemptive rate cuts, which he referred to as insurance cuts, have only occured to combat unusual events which have the ability to crash markets. His examples included the 9/11 terror attacks and Black Monday. It may be hard to find a trader, economist, or even speculator who would claim the current situation resembles either example in the slightest.
So what gives? Why is the Federal Reserve lowering rates when the economy seems to be chugging along just fine? The answer, as readers might surmise, is Donald Trump. Since he has taken office, the FOMC has initiated a rate hike seven times, compared to just twice in his predecessor’s presidency. Each time, Trump has decried the increase, asserting the Fed and his chosen chairman, Jerome Powell, were not heeding the economic data. Data since would suggest they chose the appropriate monetary policy, but that isn’t the point of this article. The economy has improved significantly since Obama took office during the Great Financial Crisis, but rate hikes are tough to swallow for any president. Frustration can be expected.
What separates Trump from presidents of the last few decades however, is his vocal and public attacks on the Federal Reserve. Breaking from a tradition of administrations declining to comment on Fed monetary policy, he and his aides have criticized the central bank on television, during political rallies, and in otherwise unrelated speeches. In the process, he has done much to taint the public’s trust in the Federal Reserve’s independence.
Among the characteristics desired in a central bank, none is more important than independence. The insulation of a central bank from political pressures, and a resulting decision-making process rooted in academic research and economic data, assures market participants that the institution acts solely for the benefit of the economy. With every attack, the probability that market participants second-guess the central bank’s reasoning for policy grows higher. When the FOMC increases the fed funds rate, people think, “are they just doing it to show independence or does the economic data actually suggest a rate hike?” If the FOMC decreases the fed funds rate in the coming days, people might think, “ah, Powell has finally succumbed to pressure from Trump.” Whether or not that is true will no longer matter; perception is reality when the central bank moves.
When the FOMC convenes at the end of July, it is likely to approve a decrease in the fed funds rate of 25 bps. Given recent speeches by various members of the committee, a large part of the reasoning will likely be global uncertainties related to the ongoing trade war, along with slowing growth in Europe and China. What should concern the public however, is how the situation that led to this rate hike came about. Trump may have failed to pressure Powell into a rate cut through words alone, but by initiating an economically taxing trade war while simultaneously demanding interest rate cuts, the president has forced the hand of Jerome Powell.
While the trade war began on the premise of trade imbalances (a poor reason) and unfair foreign intellectual property rules (a far better one), it has been co-opted as a way to force Powell to heed Trump’s desires for lower interest rates. As the trade war drags on, economic uncertainties mount and the Fed is forced to address the domestic implications. At this point, the administration has probably realized this also and will exploit it in anticipation of the upcoming presidential election.
Whether or not Trump “wins” his trade war doesn’t matter in his pursuit of lower interest rates from the Fed. If he does, the concessions will likely be small and insignificant; China is far too large an economic power to concede much of anything to the United States, and nationalist fervor would make it unacceptable in any case. If Trump doesn’t win, he will still have dragged on the trade war long enough to force the FOMC to approve what might be several rate cuts by the time the election is held.
Cynical critics of the president might suggest the entire trade war was started to compel the Fed to lower interest rates when speeches alone were insufficient. Defenders will likely point to the problems with our economic treaties and a history of presidents attempting new trade agreements. Both sides could be right and it wouldn’t matter. Not since the days of Arthur Burns and Nixon has a Fed chair been subject to such public attacks. As the trade war wages on and the Fed responds accordingly, some people will inevitably conflate Trump’s demands with the Fed’s decisions and argue the central bank’s independence has been tarnished. Trump should be careful about what he says about the central bank. If a recession does happen on his watch, it is the central bank’s independence that will stabilize markets and save him.
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