The Fed Trumps Trump
Policymakers at the Federal Reserve are expected to raise short-term interest rates again in December, which would be the seventh such increase since President Trump took office, and they may ratchet them higher three more times in 2019. The number of critics of the Fed’s tightening are few, but one of them is President Trump himself, who has chastised Federal Reserve Chairman Jerome Powell, his own appointee, for the fast pace of interest rate increases. Speaking about the Fed chairman, Trump told the Wall Street Journal on October 23 that “it almost looks like he’s happy raising interest rates.” The image is one of a 19th century banker twirling his mustache as he snaps his lash over the heads of cowering debtors.
The President is right to be concerned. Excessive Fed hawkishness right now is a serious danger to the economy. Over the past year the move toward higher interest rates has been justified on grounds that a robust economy gives the Fed a window for returning short-term interest rates to a “normal” range, after a decade of keeping them near zero because of the 2007-08 Financial Crisis. Getting back to normal may be a laudable policy goal, if, as economists say, all other things being equal. But all other things are not equal. The Trump tax cut changed the macro-economic context.
The Tax Cut and Jobs Act of 2017 reduced the corporate tax rate to 22% from 35%. This is an important change because the lower tax rate encourages the creation of new productive capacity, which in turn increases the demand for dollars to fund it. The Fed should accommodate this demand by injecting liquidity into the system. Instead it is doing the opposite. Raising short-term interest rates has the effect of stifling the demand for dollars.
Several features on the political and economic scene begin to emerge from all this:
- The Federal Reserve is staking out a position where it has veto power over tax policy. Now the Fed governors may not have that intention, and they may say their decision-making is guided by the public good; nonetheless raising interest rates at the present time has the net effect of depriving the Trump tax cut of traction. The Fed has the upper hand here because higher interest rates are more powerful than lower tax rates. That’s because lower tax rates are merely permissive on expansion — they can only create an enabling — whereas higher interest rates are compulsive on contraction — they stop the activity of marginal producers who could be in business if borrowing costs were lower. In short, if the Fed continues on its present course, it can trump Trump.
- Monetary nullification of the Trump tax cuts will demoralize the public, which will become more wary of future efforts to lower taxes. The Administration has promised that the 2017 tax cut will get the economy out of its long-term slow-growth rut. If the economy has insufficient liquidity to fuel expansion, it could easily revert back into a pattern of slow growth. The Left will then complain that the tax cuts benefited only the rich and that cutting taxes is the root cause of the federal deficit. “Experts aren’t sold” is a typical headline doubting the efficacy of the Trump tax cut. Those experts could be right. The capital gains tax cut will not have its optimal effect if the Fed puts American businesses on a budget of stingy liquidity.
- Traditionally, Democrats tend to be more dovish on interest rates than Republicans, who tend to be enamored of something called the “strong dollar.” What’s missing from the current policy battle is the sound of Republican artillery laying down supporting fires for President against the Fed. If Democrats gain control of the House of Representatives in this year’s election, we may see the President making common cause with them for a looser monetary policy. This in turn may set a pattern for future Trump-Democrat collaboration on immigration reform and the southern border, with Republicans in a secondary role.
- The nightmare scenario is Japan. The Japanese economy over the past thirty years is a case study of the long-term effects of deflationary monetary policy. It is a cautionary tale one hopes the Fed governors know well. It is not known if the shoguns who run the Bank of Japan ever looked “happy raising interest rates,” but fair to say they take pride in having kept inflation at bay. The cost has been terrible: Japan has endured two generations of lost economy opportunity. It’s still stunning to realize that the widely watched Nikkei Stock Average is some 45% below its historic high reached in December 1989!
Today the Fed says higher and the President says lower. Both sides should sit down and work out an objective standard for setting interest rates. Ideally, the way forward would be a move toward monetary reform, which was discussed earlier here: the Federal Reserve should discard its short-term interest tool in favor of direct open-market operations to inject or drain liquidity into or out of the economy; commodity prices, especially gold, should guide decisions on Fed interventions; and the world should re-establish a regime of fixed exchange rates.
Correction: tax rate reduction was corporate tax rates, not capital gains, as erroneously stated