“Well, it's staying at zero because she's [former Fed Chair Janet Yellen] obviously political and doing what Obama wants her to do. […] I used to hope the Fed was independent. And the Fed is obviously not independent. It’s obviously not even close to being independent."
Candidate Donald Trump, CNBC, September 12, 2016.
“I put a very good man in the Fed. I don’t necessarily agree with it because he’s raising interest rates [...] I don't like all this work that we are putting in to the economy and then I see rates going up….
President Donald Trump, CNBC, July 19, 2018.
“China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field...”
President Donald Trump, Twitter, 5:43AM, July 20, 2018.
“….The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates – Really?”
President Donald Trump, Twitter, 5:51AM, July 20, 2018.
Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.
Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets. The unemployment rate is testing 50-year lows, the expansion is posed to become the longest on record, and financial conditions remain highly supportive, with the stock market 30 percent above its November 2016 level.
The President’s admonishment also comes despite the Fed’s continued accommodative stance. Using various estimates of the equilibrium real interest rate (r*) and the unemployment gap—the difference between the actual unemployment rate and the equilibrium rate (u*)—a simple Taylor Rule points to a federal funds rate one to three percentage points higher than the current 1.9%. And, while it is now gradually declining, at $4.3 trillion, the Fed’s balance sheet remains enormous. That is, U.S. monetary policy might be tightening, but it is by no means tight.
Trump’s criticism also has come despite the sizable fiscal stimulus enacted at the end of last year and earlier this year. Indeed, by our reckoning, the mixture of tax cuts and spending increases this year and next constitutes the most pro-cyclical kick to the economy since the Vietnam War in the 1960s. In the following chart, the vertical axis shows the fiscal stance: the more negative the number, the larger the stimulus. The horizontal axis shows the gap between the unemployment rate and the equilibrium rate (“natural rate”) of unemployment: the more negative the number, the tighter the labor market. Fiscal policy is pro-cyclical in the upper right and lower left regions, where fiscal expansion or contraction is associated with an unemployment rate below or above the equilibrium. As the IMF noted in its 2018 review of the U.S. economy, this year’s stimulus lies clearly in the lower left, with the unemployment rate already lower than what most analysts expect to prevail in the long run.
United States: Fiscal thrust versus unemployment gap, 1966 to 2019
Note: The fiscal thrust on the vertical axis is the annual change in the cyclically adjusted fiscal position as a percent of GDP. The unemployment gap is the difference between the unemployment rate and the CBO estimate of the natural rate (u*). The data through 2016 use the CBO’s estimates of automatic stabilizers to show the change in the federal government cyclically adjusted fiscal position as a percent of GDP. The estimates for 2017 to 2019 utilize the change in the IMF World Economic Outlook measure of the general government deficit as a percent of potential GDP. The unemployment gaps for 2018 and 2019 utilize the IMF WEO forecasts for the unemployment rate and the CBO’s estimate of u*. The vertical blue line denotes a zero unemployment gap, while the horizontal blue line marks a neutral fiscal stance. The figure is similar to the chart on page 9 of the IMF 2018 Article IV report on the United States. Sources: Congressional Budget Office, IMF and authors’ calculations.
Such a procyclical fiscal boost has both short- and long-term implications for monetary policy. First, as the FOMC has repeatedly indicated, after a decade of necessarily extraordinary accommodation, this is the time to normalize interest rate policy. Trend inflation—measured by the core personal consumption expenditures (PCE) price index (up by 1.9% from a year ago in June) or by its trimmed mean (up by 1.8% from a year ago in May)—is now virtually in line with the Fed’s target. With the economy growing beyond its sustainable pace and employing available resources at or beyond normal levels, there is little justification for monetary or fiscal stimulus, let alone both. The President’s currency anxieties aside, despite the relative cyclical strength of the U.S. economy, even the dollar is only a few percent above its long-run average on a real, trade-weighted basis.
Second, there is the question of how high policy rates should go. As we have written in the past, r* appears to have fallen substantially over the past decade. But the current pro-cyclical fiscal stimulus likely will boost r* at least somewhat. There are two possible reasons for this, improved growth prospects and crowding out. We are skeptical that the tax cut will foster faster productivity growth, limiting its impact on the long-run economic outlook. Both private (Survey of Professional Forecasters) and public-sector projections (see Appendix A, the Summary of Economic Projections and the WEO database for the CBO, FOMC and IMF outlooks, respectively) anticipate long-run growth in the range of 2%, well below the Administration’s 3% expectation. By contrast, we are more open to the possibility that crowding-out effects from the prospective increase in government debt will nudge r* higher. That is, the Treasury will have to offer investors higher interest rates to entice them to hold the rapidly swelling stock of U.S. government bonds. Even assuming a 2026 reversal of the “temporary” tax cuts implemented this year, the CBO recently raised its long-run projection for the federal debt-to-GDP ratio in 2040 to 124% from 78% this year.
What does the Fed anticipate for monetary policy? In the FOMC’s latest Summary of Economic Projections, the median estimate of the equilibrium nominal federal funds rate (which adds the FOMC’s 2% inflation target to its members’ implicit estimates of r*) is just shy of 3%. The median FOMC projection at the end of 2019 would be only a tad higher, consistent with two more 25-basis-point rate hikes this year, and three hikes next year. While market expectations (as embodied in federal funds rate futures prices) fall a bit short of these projections, the FOMC’s gradual plan appears conservative. It shows little or no monetary policy adjustment for the unusual fiscal stimulus in place or for the possibility of a large price shock from the recent and prospective imposition of tariffs. So, absent a change in the economic outlook, we expect the Fed to continue pursuing this gradual course or, possibly, to act faster. Not only will they raise rates, but their estimate of the long-run resting point could rise, too.
Far more important than the exact path of policy rates is that—regardless of what the President may or may not say—we expect the FOMC to remain faithful to its legal mandate of maintaining price stability and maximum sustainable employment. While the Federal Reserve is genuinely independent, that “independence” is highly circumscribed. Consistent with the effective and legitimate delegation of authority to unelected officials, the Federal Reserve Act sets out clear objectives for monetary policy as well as precise tools that the Fed can use (for example, by specifying the assets that it can acquire). To hold the Fed accountable, Congress requires an appropriately high degree of transparency. In addition to frequent testimony by Fed officials, the FOMC regularly issues policy statements and reports, publishes its minutes and its members’ forecasts and, with a lag, releases the transcripts of its meetings. The Fed also publishes its balance sheet weekly, and (again with a lag) provides full details of every financial transaction (including the volume, term, rate, counterparty, and collateral value).
Put differently, Federal Reserve independence is operational: the central bank can use its tools in the ways that it judges most appropriate to satisfy its mandated objectives. This means taking actions to set interest rates and alter its balance sheet that are not subject to reversal by the legislative or executive branches of government. At the same time, Congress routinely reviews the Fed’s policy outcomes, ensuring its legitimacy by holding it publicly accountable.
As is the case in many other countries, the U.S. Congress has given the Federal Reserve this instrument independence in the belief that it will improve economic performance. Because people are forward-looking, effective central banking is about strategy and credible commitment—including the commitment to price and broader economic stability. Delegating monetary policy authority to nonpartisan technocrats—within a framework of transparency and accountability with clear objectives—helps anchor people’s future expectations by limiting officials’ temptation to renege on long-run commitments for short-run purposes. The point is to avoid the classic temptation politicians have to keep interest rates low to foster a pre-election boom, with the inevitable burst of inflation coming only later. The Fed welcomes public review, because it knows that transparency increases its credibility and helps condition our expectations of the future.
Here, the Fed has been remarkably effective, anchoring long-term expectations in a manner consistent with securing price stability. Each January since 2012, the Federal Open Market Committee has laid out in detail its monetary policy strategy to achieve the goals set out in the law. That strategy includes a specific target for inflation: 2% based on the PCE price index. (Because of differences in methods and coverage, the 2% PCE inflation target is consistent with annual increases of about 2.2% in the more well-known consumer price index (CPI).) Importantly, the Fed has no specific goals for the equilibrium unemployment rate, which primarily reflects non-monetary influences. As the chart below highlights, both professional forecasters and financial market participants’ latest long-run projections for CPI inflation are almost exactly in line with the Fed’s target. That is, when the FOMC says it will keep inflation near 2%, people believe them. The target is credible.
Long-run CPI inflation expectations: professional forecasters and the market for U.S. Treasury notes, 4Q 1991 to 2Q 2018
Notes: The solid red line is the median projection for average CPI inflation over the next 10 years from the Survey of Professional Forecasters, while the surrounding gray-shaded area shows the interquartile range. The dotted black line is the five-year-forward, five-year breakeven inflation rate based on the market for U.S. nominal and inflation-indexed Treasury notes. Sources: FRB Philadelphia and FRED.
This hard-earned achievement has wide-ranging benefits. First, households and investors can make plans for the long run without worrying much about the path of aggregate prices. This facilitates the efficient allocation of labor, capital and other resources. Second, by keeping inflation expectations both low and stable, the Fed has reduced the inflation risk premium in the long-term bond market. The result is both lower costs of new debt to borrowers (including households and firms) and a reduction in the ultimate burden on taxpayers of supporting the rising level of public debt. Third, having established its long-run credibility, the Fed can act more aggressively to stabilize the economy in the face of short-run disruptions—like the doubling of oil prices in the year to June 2008—without boosting long-term inflation expectations. Finally, in the face of deep downturns, like the recession of 2007-2009, the Fed’s symmetric commitment to price stability helps to prevent the spread of destabilizing deflationary expectations.
No one with a long-run view of U.S. economic interests would care to risk these enormous benefits, especially not Fed officials. That is why we fully expect the central bank to stick to its knitting: to follow its legal mandate and its stated operational strategy without regard to criticism expressed by politicians, even including the President. When asked, we expect Chair Powell and other officials to continue to explain, as they have for years, that the FOMC acts to achieve the goals set out by Congress.
The danger, of course, is that operational independence is fragile. As a body led by unelected officials, the Fed has a very weak hand to play in a public battle with any President. The disastrous experience with President Johnson—when the Fed last faced a Commander in Chief who wanted to keep interest rates low despite a large pro-cyclical fiscal stimulus—is a case in point. As former FRB Richmond President Lacker highlights, the Fed’s caution under pressure in the mid-1960s helped set the stage for the greatest peacetime inflation in U.S. history. We strongly doubt that the current members of the Fed would repeat this error.
In the extreme, however, Congress and the President can alter the Federal Reserve Act whenever they want (as they did when enacting the Dodd-Frank Act in 2010 and the EGRRCPA earlier this year). Far short of that, sustained criticism by the President of interest rate increases, regardless of the policy and economic environment, can undermine public confidence in the sustainability of the Fed’s operational independence. If such fears lead to rising long-term inflation expectations, the cost could be rising risk premia, larger-than-projected increases in policy rates and perhaps even an unnecessary recession.
For all our sakes, we hope that the President chooses to leave the Fed alone to do the job they have been doing well for decades. But the incentive to find a scapegoat will grow if, as we and most observers expect, the economy fails to meet the Administration’s very rosy expectations while the Fed continues to normalize interest rate policy in an effort to keep inflation close to 2% and ensure a sustainable pace of growth.