Recent tension between Donald Trump’s White House and the US Federal Reserve has been viewed by many as an improper ratcheting up of political pressure on the central bank. That is true. But there is light as well as heat here — and important questions about how monetary policy is formulated and how it is communicated.
The immediate source of the tension has been the risks faced by the US economy. Last autumn, a sharp decline in equity valuations tightened financial conditions. And growth prospects in China and Europe slowed, posing risks to the US outlook. Yet wage growth, the low unemployment rate and potential financial excesses (sometimes a sign of overheating) bolstered the Fed’s case for strength, not weakness, in the economy.
The balance of these risks were no doubt considered before the Fed’s last interest rate rise in December 2018. My own judgment is that this increase in the federal funds rate was unwise. So a reduction in the policy rate at the next meeting of the Federal Open Market Committee on July 30-31 would be a welcome precaution.
But arguments over rate rises mask a bigger issue. The Fed should also think about an inflation target with an average over a defined period of time — signalling a willingness to allow inflation to rise above 2 per cent for a while to make up for the period when it fell below 2 per cent. That would be useful in general, and as a politically neutral explanation for a less restrictive policy stance.
The Fed also seems to have given little attention to the supply-side benefits of the significant reduction in corporate tax rates contained in the 2017 Tax Cut and Jobs Act. Instead it has focused mostly on the effects on aggregate demand of a short-term rise in the federal budget deficit. The supply-side benefits of the tax changes, due to greater business investment, would further reduce inflation pressures.
But the White House is also missing a bigger picture. The real risks to the US’s growth prospects and, importantly, to the business investment needed to extend the upturn in productivity growth do not come principally from the Fed. Rather, they are the product of global economic weakness, which is not easily influenced by the US, and uncertainty surrounding American trade policy, which it can, of course, control.
While one can debate the merits of the more aggressive US trade stance towards China and even some allies, the accompanying uncertainty and volatility raise the risk premium for business investment. This concern was expressed at length in the minutes of the June FOMC meeting. Just as the Fed placed too little weight on the significance of the corporate tax cut for its view of the path of inflation, so the Trump administration has not thought hard enough about the benefits of its tax cuts. It has allowed policy uncertainty to undermine the beneficial effects on private sector investment and productivity.
Disagreement over the federal funds rate is preventing the White House and the Fed from improving their relationship and communicating better. The administration could refocus on fiscal policy and try to ensure a more predictable climate for business leaders. Meanwhile, arguments over interest rates should be part of a broader inquiry into the monetary policy framework in the post-financial crisis economy.
Such a review could, for example, assess whether the 2 per cent inflation target continues to influence expectations and outcomes in the way the Fed assumes. Another question is whether the Phillips curve — the relationship between inflation and unemployment — still obtains. And perhaps most significantly, does the Fed possess the tools in a period like the present to achieve a desired level of inflation?
The Fed should aim for greater clarity over its inflation objective, the path of its efforts to shrink its balance sheet and its evolving definition of “data dependence”. And a genuine listening tour with diverse — and credible — expert voices would be useful. But none of this should be allowed to threaten the central bank’s independence, which is hard-won and not to be compromised.
The Fed will probably alter its policy stance somewhat at the forthcoming FOMC meeting. Chairman Jay Powell signalled as much in recent congressional testimony. And the White House may or may not be happy as a result.
But, whatever the outcome for interest rates, there are bigger ideas and policy issues at stake in the current war of words. Arriving at a thoughtful truce and finding a path forward is in both parties’ interest. It will pay important economic dividends, too.
The writer is dean emeritus of Columbia Business School and previously chaired the US Council of Economic Advisers