How the US Fed Tries to Discipline Trump

Today the Board of Governors of the Federal Reserve Bank raised the U.S. interest rate for the third time in 2018 by 25 basis points, to a rate ranging between 2.00% and 2.25%. In doing so, the Fed effectively continues to act as a substitute for responsible fiscal policy.

In the traditional model, fiscal policy and monetary policy are to complement each other in steering the economy through business cycles. Tighter fiscal policy and higher interest rates are applied to put breaks on an overheating economy. Conversely, deficit spending and lower interest rates jump-start a weak economy.

This all changed when President Obama took office in January 2009. The economy was losing 800,000 jobs a month in the United States’ deepest recession since the Great Depression of the 1930s.

While Obama pushed a stimulus package through a very reluctant Congress, the package was far too small and heavily tilted towards tax cuts rather than investments.

As a result, economic growth and especially job growth remained weak in the United States during 2009 and in the following couple of years, extending the suffering of average Americans. The Fed already had lowered interest rates to 0% to stop the bleeding.

As additional Congressional action to promote economic growth was not forthcoming, the Fed felt compelled three times to implement so-called quantitative easing policies by buying up private-sector financial assets.

This strategy managed to lower long-term market interest rates, which made borrowing cheaper, debt more affordable and stimulated some growth. In the process, the Fed quadrupled its balance sheet.

Tamping down on fiscal recklessness

Today’s action by the Fed to raise rates is intended to do the opposite of what the Fed felt compelled to do during the Obama Administration. Current interest rate increases are to tamp down the possibly very dangerous effects of fiscal recklessness during a time of a booming economy.

The Trump Administration and the Republican Congress approved a reckless tax cut in 2018. This tax cut will add nearly $2 trillion to the country’s debt by 2028, according to the nonpartisan Congressional Budget Office (CBO). In addition, Congress approved a lavish spending package.

As a result of both, the fiscal deficit will nearly double as a percentage of GDP in 2018 when compared to 2015. This procyclical fiscal stimulus has already led to overvalued stock markets and an overheating real economy.

The Fed’s shortcomings

The Fed’s efforts to make up for the failures of fiscal policy over the last nine years has several shortcomings. First, monetary policy is always a much blunter and less effective tool than fiscal policy. In other words, monetary policy cannot make up for fiscal policy errors.

Second, and partly as a result of the former, this monetary policy leads to overvalued financial markets in good times and in bad times. This causes grossly inflated valuations and one giant asset bubble through recessionary and expansionary periods.

In other words, the continuous pursuit of a procyclical fiscal policy (too tight during a recession and too loose during an expansion) and counter-cyclical monetary policy to compensate for the former leads to seemingly permanent financial bull markets, whether the economy is expanding or shrinking.

As a result, U.S. financial markets have become completely detached from the fundamentals of the real economy. This lack of policy cohesion where fiscal and monetary policy do not work in conjunction, but where the latter is trying to make amends for the failures of the former, further stretches the limits of the capitalist model.

Unless or until the executive and legislative branches of the U.S. federal government decide to re-adopt prudent counter-cyclical fiscal policies to help the economy manage business cycles, the primary consequence is clear: It leaves the burden of policy-making to the central bank, which at some point risks a major financial crisis that once more will rob the American people of their savings as Wall Street drags down Main Street.