Fed bashing is a fool’s game
President Donald Trump has publicly rebuked Federal Reserve Board Chairman Jerome Powell for what the president regards as misguided interest-rate increases that threaten continued economic expansion. This way of doing business is counterproductive – irrespective of whatever merit Trump’s underlying position may have.
No central banker can be seen as yielding to pressure from a politician facing a difficult election. A central bank that appears subservient to political concerns will rapidly lose credibility in the markets, resulting in increases in inflation expectations and rising longterm interest rates. As those of us at the Treasury Department used to remind White House political staff during the Clinton administration: Fed bashing is a fool’s game – the Fed doesn’t cut short rates, and the market raises long-term rates. The sense that policy is being politicized increases uncertainty, which is likely to decrease investment and ultimately slow growth.
So Trump is surely making a serious error. Two questions remain. First, how rapidly should the Fed raise interest rates in coming months? Second, what should be the nature of relations between the central bank and the executive branch? On neither question does orthodox thinking seem quite right to me.
On the first question, it seems there is considerably more danger of the Fed raising rates too fast than too slowly over the next year. Inevitably, monetary policy is a judgment about competing risks. If the Fed raises rates too slowly, inflation will increase and remain clearly above the 2 percent target for a significant interval. This does not seem like it should be a dominant worry. Inflation has been below the target level for a decade, so above-target inflation is necessary if inflation over the long term is to average 2 percent.
Even with good luck and good policy, a recession will come along at some point and pull down the inflation rate. Two months ago, it might have been reasonable to worry about complacency in asset markets, but in light of recent volatility, this seems a lower-order problem.
On the other hand, the risks of excessive tightening seem substantial. Monetary policies affect the real economy with lags of a year or more. It is, therefore, easy for policy to tighten past the point at which the economy is thrown toward recession because of an absence of clear signals of slowing. Indeed, on almost every occasion in the past 50 years when the Fed has tightened in a sustained way, the result has been recession. The risks of a downturn now are greater than at any point in living memory because, given the zero lower bound on interest rates, the Fed would have limited room for easing, and because of the populist and protectionist pressures that would almost certainly accompany a downturn.
Second, there is a need for pragmatism regarding the independence of central banks. It is important they resist the kind of pressure for inflationary policy that Trump has engaged in. But it is foolish to suppose that a nation’s financial policies should be conducted entirely independently of its elected officials.
The point is not that central banks should be made more subject to political pressure. It is that, as their activities expand beyond pure monetary policy, there will be a need for coordination between the banks and elected government.