Presidents Should Leave the Fed Alone

L: The always astonishing President has recently criticized the FOMC interest-rate increases, among other things. He complained that it takes away from the United States’ “big competitive edge.” Reuters reports: "Trump, in posts on Twitter, also lamented the strength of the U.S. dollar and accused the European Union and China of manipulating their currencies....Trump, however, has made reducing U.S. trade deficits a priority and the combination of rising interest rates and a strengthening dollar pose risks for export growth."

So I ask my favorite economic forecaster 2 questions: 1) What do you think about the President directly addressing Fed policy? and 2) How are interest rates, foreign trade and dollar-strength related? [Warning: this answer is longer than a normal blog because Jim CANNOT answer a question without historical context.]

J: Let's get that second question out of the way. No one really knows if there is any relationship at all among interest rates, foreign trade, and the strength of the dollar. But it's not for lack of trying. Hundreds, if not thousands, of books and millions of articles have been written on these topics yet there is no accepted explanation.

The answers all depend on what else is going on in the global economy at any given time. A strong dollar may make it more difficult for firms to export, but if their productivity is growing quickly enough or if their goods or services are quite superior to others in the marketplace, the strong dollar won't matter.

If an economist could come up with the answer to that question that was empirically documented and generally accepted, she or he would be a shoo-in for the Nobel Memorial Prize in Economic Science. So far, there are no candidates in this area of economic research. Which leads us to the conclusion that the President's comment accusing rising interest rates and a strengthening dollar of depressing export growth is an unfounded complaint.

Regarding the question about Presidents addressing Fed policy, all politicians like low interest rates and steady economic growth. Populist presidents do not like a central bank that has the power to nudge the economy (and prices) one way or another. But if they act on their instincts, bad things happen.

Probably the most dramatic example was in the Jackson administration (1829-1837). President Jackson hated the Second Bank of the United States and thought his reelection in 1832 gave him a mandate to get rid of it.

He had trouble finding a Treasury Secretary who would take the government's cash out of that bank and put it in a variety of state banks, so he fired two of them and installed Roger Taney, who was the Attorney General, in a recess appointment in 1833. Taney promptly pulled federal government funds out of the bank, which doomed it no matter what happened with the decision on the renewal or cancellation of its charter in 1836. Subsequently, Mr. Taney became the first nominee for a Cabinet post to be rejected by the Senate (on a 28-18 vote) in 1834. President Jackson had already gotten what he wanted and later nominated Taney to be the Chief Justice of the Supreme Court after John Marshall died in 1835.

(Interesting side facts: Mr. Taney was the Chief Justice until he died in 1864. Perhaps his most egregious action in that role was the Dred Scott decision of 1857. That 7-2 vote is generally considered the worst Supreme Court decision ever. It said that African-Americans could not be US citizens and could not sue for their freedom. It took the Civil Rights Act of 1866 and the 14th Amendment to the Constitution to correct this abominable decision, not to mention the biggest war ever fought in the US. Roger Taney's wife, Anne Phoebe, was the sister of Francis Scott Key. They had six daughters and a son who died in infancy.)

The demise of the Second Bank of the Unites States in 1836 led directly to the Panic of 1837. That was the biggest economic disaster ever to befall the country at that time. (L: Bad ending to presidential meddling.)

We had no central bank from 1836 to 1913, when Representative Carter Glass (R-VA), working with Professor H. Parker Willis, then at Washington and Lee University and later at Columbia, succeeded in convincing President Woodrow Wilson that the US needed a strong central bank. The Federal Reserve Act was signed into law at the White House on December 23, 1913.

President Lyndon Johnson criticized the Fed several times as did his successor, President Nixon. Their pressure succeeded in causing the Fed to let the money supply grow too fast, resulting in serious inflation. (L: Another bad ending to presidential meddling.]

President Carter was forced by public pressure caused by that high inflation to nominate Paul Volcker, then-President of the Federal Reserve Bank of New York, to be Chairman of the Board of Governors of the Federal Reserve System. (L: Today's Chair is Jerome Powell, succeeding Janet Yellen.) The Senate confirmed him on August 2, 1979, by a vote of 98-0. He led the Federal Open Market Committee (FOMC) to a new policy of trying to control the rate of growth of the money supply without worrying about what happened to the Federal Funds rate.

That resulted in the Fed Funds rate hitting an unprecedented 17.2 percent in March 1980 during the January to July 1980 recession. (L: Today the Fed Funds rate is 2.0 percent.) That recession, while quite deep, was the shortest one (at six months) in US business-cycle history going back to December 1854.

All the turmoil in the economy in 1980 not only greatly helped Governor Reagan beat President Carter but also brought in a Republican majority Senate for the first time since 1953. However, the need to get inflation under control continued.

As the chart shows, the Federal Funds rate hit 18.9 percent in December 1980, 19.08 percent in January 1981 and a record 19.1 percent in July 1981. [L: I believe I bought a house right around then. I was the buy-high, sell-low poster child, buying a house just before the 1980 recession and while the interest rates were sky-high.] Those high interest rates led the economy into a 16-month recession from July 1981 to November 1982. That was the recession in which the unemployment rate peaked at 10.8 percent in both November and December 1982. [L: Oh, did I mention I was living in central Ohio where the unemployment rate peaked around 25 percent? Ugh.]

President Reagan never publicly chastened the Fed. He DID nominate Alan Greenspan to succeed Paul Volcker as Chairman in 1987 with the understanding that Dr. Greenspan would continue the fight to get inflation under control. That fight lasted quite a while and was very painful for US citizens. What we learned from all that was to not let inflation go crazy. And it turns out that the way to do that is to raise interest rates to slow the economy before inflation rises.

Now here we are with President Trump. He has spent his entire career before becoming a politician in the commercial real estate field. It turns out that all developers prefer low interest rates. Thus, it should not be surprising that he publicly stated that he was "not thrilled about rates going up" in a July 19 interview on CNBC. It's a bad idea for a President to try to influence the Fed, but it's not his first bad idea and certainly won't be his last.

My forecast is that the FOMC will keep raising the target for the Federal Funds rate by 0.25 percentage points at every other meeting through 2020, the President's comments notwithstanding. Since they meet eight times a year, that means two more increases this year (most likely in September and December) and four in both 2019 and 2020. All of these increases are necessary to keep inflation from rising dramatically. The goal of the FOMC, as mandated by Congress, is to keep inflation and, more importantly the expectations of future inflation, low enough that they do not enter into decisions of either businesses or consumers about future investments or spending. In practice, the FOMC has defined this goal as an effort to keep inflation close to, but slightly below 2.0 percent as measured by the Implicit price deflator for personal consumption expenditures.

As the chart below shows, they have done a great job of that in recent years.