Unemployment 3.5%, Inflation 2.3%

Update 407:  Unemployment 3.5%, Inflation 2.3%
Yet Prime Rate 1.75% — What Could Go Wrong??

What is the optimal interest rate under current economic conditions?  This question has taken on new meaning for Chair Jerome Powell of the Federal Reserve. The current federal funds rate of 1.75 percent looks like an odd spot, given the nation’s decade-long economic expansion and impressive aggregate macroeconomic stats.  

By any measure, this monetary policy leans heavily accommodative, expansionist, stimulative, dovish… pick your term.  Even so, President Trump continues to push for even lower interest rates to artificially boost the economy during the election year. Last week, Trump nominated to the Fed two Board candidates who could extend this policy well into the new decade. 

What explains such a paradoxical policy?  Who are these nominees promising to perpetuate it?  And what could possibly go wrong? See below. 

Best,

Dana

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Last Thursday, the Trump administration announced it was forwarding to the Senate the nominations of Judy Shelton and Christopher Waller to the Federal Reserve Board. The president first indicated his intent to nominate the pair to open Board seats in July. As Board members, Shelton and Waller would likely support the President’s call for low interest rates. 

  • Judy Shelton is a longtime Republican political operative who most recently served as the U.S. Executive Director at the European Bank for Reconstruction and Development (EBRD), where she frequently missed board meetings. A PhD in business administration, she has bucked modern economic thinking by advocating for a return to the Gold Standard.   
  • Christopher Waller is a less controversial nominee. He joined the Federal Reserve Bank of St. Louis in 2009 after teaching economics at the University of Notre Dame and the University of Kentucky. Waller has written extensively for academic journals on monetary policy, foreign currency markets, and macroeconomic policy. He serves as Executive Vice President and Director of Research at the St. Louis Fed where he is known for his commitment to low interest rates. 

President Trump has handpicked four of the five current members of the Fed Board, including Fed Chair Jerome Powell. If the Senate confirms Ms. Shelton and Mr. Waller, that would fill the seven-member Board with six Trump appointees. The nominees will likely advance, given that the Senate unanimously confirmed Shelton to her previous position on the EBRD and Waller is a relatively nonpartisan pick.

Interest Rate Optimality and Fed Influence

The Fed’s main lever to stimulate the economy during a recession is its ability to cut interest rates, thereby encouraging borrowing and investment in the economy. During economic expansions, the Fed has typically raised rates to provide the central bank with room to prevent an overheated economy and head off accelerating inflation. The Fed’s 2019 decision to cut rates to below two percent in the midst of economic expansion has left the U.S. economy in a potentially precarious position if another recession is on the horizon. The optimal interest rate in an expansionary period is one that discourages excessive borrowing and which could provide the Fed with enough room to cut interest rates when the economy encounters serious headwinds. 

Before both the 2001 recession and the Great Recession, the federal funds rate was above five percent. This allowed the Fed to help stimulate the economy by cutting the rate several percentage points in both recessions. With the current interest rate, the Fed will have to rely on other, less well-established, policy levers to achieve a similar level of stimulus in the case of another downturn. 

Federal Funds Rate since 2000

Source: Macrotrends

Moreover, Fed policy is taking a backseat to market activity. Wall Street now has a heavy influence on Fed actions. Powell began his tenure as Fed Chair by continuing Janet Yellen’s policy of incremental rate increases. Our economy was in the midst of one of its longest periods of economic expansion ever, and the Fed played its part by slowly raising rates so as to ensure economic stability and liquidity — not to mention breathing room in the event of another crisis.

When the Fed raised its rate to 2.5 percent in December 2018, Fed officials and experts expected the yield on the 10-year Treasury note to increase as well. That didn’t happen, and the yield curve eventually inverted. The Fed cut the funds rate — most recently in October 2019 — and the yield curve consequently steepened. Market participants still are pricing in expected rate cuts, and while Powell has delivered during 2019, it appears that the Fed is on hold for the foreseeable future, signaling neither more cuts nor a reversal of course. 

Interest Rates and the 2020 Race

While candidate Trump and fellow Republicans spent much of the 2016 campaign criticizing the Fed for keeping rates too low, President Trump is now demanding the central bank lower interest rates to continue the economic expansion. Trump has applied so much pressure on his Fed Chair that the notion of raising rates is now difficult to imagine. 

Interest rates could be the X factor in the 2020 election. After keeping rates extremely low from the financial crisis to 2018, the Fed made several rate hikes, only to reverse course and make three rate cuts of 25 basis points during 2019. Capital markets responded by setting records, increasing in value by more than 30 percent over the course of the year. Interest rate policy in 2020 will affect home buyers, retirees, credit card users, banks, and the economy as a whole, perhaps benefiting some while hurting others.

The overnight federal funds rate, which determines the price of interbank lending and benchmarks other interest rates, currently sits at 1.75 percent. To raise rates — should economic conditions warranted such a move — would solicit predictable cries from Trump and allies. If the Fed maintains or lowers the current rates, such a move might increase price inflation, inflate investment asset prices, and fuel speculative bubbles. Whether these bubbles will pop under President Trump’s watch carries enormous political implications since the President has made the economy’s performance a central message in his reelection campaign. Any economic crisis could erode support among President Trump’s supporters who stand by him for his stewardship of the economy. 

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