Fed policy could clash with Trump’s plans
President no fan of raising rates
Climbing away from Earth on the first-ever trip to a foreign body in December 1968, Apollo 8 commander and spaceflight veteran Frank Borman couldn’t help but tease his rookie crewmate.
“Don’t look down,” Borman warned Bill Anders. “You’ll get scared.”
With stock prices seemingly free of the gravitational pull of economic reality, experienced and novice investors alike could be vulnerable to acrophobia as well.
“We are in a bubble right now,” then-candidate Donald Trump said in September, before equity prices climbed another 15%. “The only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down.”
Of course, raising interest rates even a little bit is exactly what the Federal Reserve did this month, nudging benchmark rates higher by a quarter percentage point.
So consider yourself warned. “When they raise interest rates,” Trump said during the campaign, “you are going to see some very bad things happen.”
That doesn’t sound good. But those “very bad things” Trump warned about if the Fed raised rates seem not to be happening. At least not yet, and probably not for another year or two.
Historically, Fed rate hikes have not been a serious threat to stock prices if the increases were off a low base, reflected a strengthening economy and were gradual. In other words, like now. Higher rates have been lethal when rates already were elevated, or the Fed was behind the inflationary curve, or when growth was receding late in a business cycle.
The Fed’s plan to normalize credit conditions gradually, however, masks a potentially incendiary clash with the Trump administration.
While the recent quarter-point tightening was widely expected, Fed chair Janet Yellen and other top officials reportedly believe the nation’s economic speed limit — the maximum rate the economy can grow without causing much inflation — has fallen to about 2%, or at least one percentage point below the long-run number and half the administration’s 4% target.
In effect, Yellen’s Fed is the traffic cop whose radar gun is trained squarely on Donald Trump’s vision of a souped-up, reflated economy.
Labor market conditions underlie Yellen’s caution.
Inflation generally is caused by wage pressures that emerge when the pool of available qualified workers runs out. At 4.7%, unemployment is close to a level that many economists think has eliminated most slack from the labor market. The broader underemployment rate also has fallen to just over 9% from a peak of 17% in 2009. Jobless claims recently hit a 44-year low.
Raising the economic bar is a fine objective, but to achieve 4% annual growth without stoking inflation that would spur the Fed to move aggressively on rates, productivity would have to double or the number of available workers would have to be larger than widely believed.
The last time the U.S. economy grew by an average of 4% over any consecutive five-year period was in the late 1990s, as the dot-com bubble was inflating and irrational exuberance had overtaken investors.
Whatever exuberance has propelled stock prices higher for the last eight years would not necessarily qualify as irrational. Stock prices don’t trade as a multiple of labor compensation or economic growth rates; they trade as a multiple of corporate profits, and the financial deck remains overwhelmingly stacked in favor of capital over labor.
The real moment of truth for U.S. stocks will arrive when a stimulus package of tax cuts and infrastructure spending passes Congress. If that happens before Yellen’s term is up in February, rates will move higher faster. If it happens after Trump likely appoints his own Fed chair next year, it is reasonable to fear a reprise of the illadvised easy money policies of 1971-’72, when President Richard Nixon pressured Fed chairman Arthur Burns to cut interest rates and pump up the money supply to aid his re-election bid.
Until then, look down and enjoy the view.