President Trump is once again worrying his supporters and feeding his critics. This time it is about the Federal Reserve Board. The President reportedly wants the Fed to push interest rates back down, which he seems to believe will stimulate even faster economic growth. To accomplish this, he has been criticizing the Fed Chairman with his usual grace and tact and threatening to appoint new members to the Board of Governors who support this policy.
There are two aspects to this latest flap. One is economic, and on this I think the President is on shaky ground. The other is political, and though his critics are appalled by the President’s attempts to manipulate the Fed, he is not the first President to make the attempt.
On the economic side, the Fed under Chairman Powell’s leadership has pursued a thoughtful and moderate course. The actions taken by the Fed in the past to shore up the financial system and help recovery from the recession created a huge imbalance in the Fed’s balance sheet. What few realize – including some Presidents – is that the Fed influences the money supply not by printing money but by buying bonds issued by the Federal government. These bonds then become assets for its member banks, allowing them to extend more credit to borrowers. When the financial crisis hit, the Fed bought up not only Treasury bonds but the mortgage backed securities whose value was plummeting. This was a critical step in maintaining liquidity and making credit available to businesses and consumers, because otherwise the drop in the value of bank assets – in particular mortgage backed securities – would have forced them to stop making new loans.
This action also meant that the debt held by the Fed increased from $950 billion in 2008 crisis to $4.5 Trillion in 2017. This increase in debt has several undesirable consequences, as described by my friend Mickey Levy in testimony before the Senate Finance Committee: by continuing to hold mortgage backed securities, the Fed is in practice allocation credit to the housing sector over manufacturing and other sectors that contribute more to economic growth; it potentially slowed recovery by distorting lending; and the abnormal balance sheet poses risks to the Fed’s credibility and independence.
Thus since last year under Chairman Powell the Fed has been “normalizing its balance sheet” by selling more Treasury bonds than it buys. This increased supply of bonds drives down their price, and since interest equals the specified payment on a bond divided by its price, it drives up interest rates. At the same time, the Fed has made carefully timed statements about its outlook for growth and inflation and its resulting decisions about whether and how much to raise its target range for interest rates.
President Trump does not like this. Despite the careful and measured way in which the Fed is acting, and its flexibility in accommodating short term shocks like fears of trade wars, the President is blaming the Fed for slowing growth during the second half of his term. The robust growth and historically low levels of unemployment we now see are clear indicators that the economy is growing about as fast as possible. If anything, it is the availability of qualified workers that is preventing faster growth, not the Fed, and getting immigration reform of a kind that will allow greater numbers of qualified workers would be most likely to stimulate more growth.
If the Fed does not take this opportunity to shed the debt it acquired as an emergency measure, the risks to economic growth in the longer term will be much greater, as Levy and other experts emphasize. In this light, I think that Trump’s promised nominees, Herman Cain (whose name was withdrawn last week) and Stephen Moore, are potential wreckers if appointed to the Board of Governors. In addition to their advocacy of unwise policies, neither has any appreciation of the subtlety required for the Fed to maintain stable expectations about monetary policy. The President should get back to work on the kind of immigration reform he has advocated in the past, which will aid faster growth, and leave the Fed alone.
But he is not the first President to attempt to bully the Fed into providing easier money. Lyndon Johnson went much further than Trump has gone in butting heads with the legendary William McChesney Martin, appointed by President Truman to be Chairman of the Fed. Johnson had dug himself into a deep hole in his attempts to hide the cost of the Vietnam War and the Great Society through deficit spending, and he wanted Martin to help him out by printing more money for him to spend on those signature initiatives.
In late 1965, the Fed raised short-term rates because of its fear that the rising deficits would accelerate and lead to inflation. Johnson flew into a typical rage, summoned Martin to his ranch and bullied him in an attempt to change the Fed’s policies. He is quoted as saying “Martin, my boys are dying in Vietnam, and you won’t print the money I need.” Johnson was advised by his Attorney General, Nicholas Katzenbach, that he could not legally remove Martin from office because disagreeing with administration policies did not constitute “termination for cause.” Martin went ahead with raising rates, but as later events proved his actions were too little and too late to prevent the rampant inflation and stagnation that appeared during the Nixon administration and continued through President Carter’s term.
Economist Bill Nordhaus at Yale University noticed that less public manipulation of the Fed by sitting Presidents has been frequent. In his article “The Political Business Cycle,” Nordhaus noted how often an easy money policy had been chosen in advance of elections in which an incumbent President was running for re-election. With the open dust-ups between Presidents and Fed chairmen being relatively rare, the explanation for how this works has to be more informal communication and pressure. This was documented clearly in the case of the Nixon Administration.
As others have noted, the Trump Administration does not go in for back channel communications, and his disagreements with the Fed started out and remained public. Fortunately, after an initial hiccup markets appear to be discounting anything real coming out of this fracas, as the lessons of history imply. More disturbing is that President Trump has put himself in the company of deficit spenders like Johnson, putting short-term stimulus for political gain ahead of policies conducive to sustained growth. That is a sin far too many Republicans, anxious to keep on doling out favors like the ethanol subsidy and spending on unnecessary infrastructure to their constituents, are willing to ignore.
David Montgomery is retired from a career of teaching, government service and consulting, during which he became internationally recognized as an expert on energy, environmental and climate policy. He has a PhD in economics from Harvard University and also studied economics at Cambridge University and theology at the Catholic University of America, David and his wife Esther live in St Michaels, and he now spends his time in front of the computer writing about economic, political and religious topics and the rest of the day outdoors engaged in politically incorrect activities.