Waging War on the Fed

The opening salvo

Waging War on the Fed

It was inevitable that President Donald Trump would comment on U.S. monetary policy.



The President has shown little regard for precedent or institutional norms if he sees them as obstructions on the path to realizing a goal. The Trump administration wants to fire things up: animal spirits, productivity, and economic growth. The Federal Reserve (Fed) is leaning the other way. Dress it up anyway you want but the goal of the rate hikes is to slow things down in order to prevent the economy from exceeding its potential and overheating.

What the president said to CNBC's news anchor Joe Kernen in his July 20 interview was, "I'm not thrilled because every time we go up they want to raise rates and I am not happy about it."

The gush of commentary that has followed has focused on the implication for Fed independence. Most conclude that the Fed has faced White House pressure before and will stand up for itself again. And Treasury Secretary Steve Mnuchin did officially reaffirm the Fed's independence only a few days after the president's interview.

No one can say how this latest White House challenge to the Fed will evolve.

It seems unlikely that interference will go as far as the situation in Japan, where the Bank of Japan (BoJ) has effectively become a vassal of the government. Prime Minister Shinzo Abe campaigned in 2012 on a platform that included getting rid of the incumbent BoJ chairman, and embarked on a radical plan to end Japan's deflation. Six years later and with the BoJ's balance sheet near 100% of gross domestic product (GDP), the central bank has been forced to extend its unorthodoxy indefinitely, even with the Japanese economy expanding steadily and wage growth finally emerging. A small rise in interest rates has enormous fiscal implications with government debt at 250% of GDP. History may determine that the government was correct to coerce the central bank into its current position, but in the interim, the BoJ seems to have lost its independence.

But President Trump's rebuke of domestic monetary policy was no off-the-cuff remark. It had been foreshadowed several times this year by similar critical comments from two administration officials: Larry Kudlow, Director of the White House National Economic Council, and Peter Navarro, Trump's trade advisor. A third, Mick Mulvaney, the White House Budget Director, went to bat defending the president's criticism of the Fed the day after he made his remarks.

At the heart of the White House dispute with the Fed is a fundamental disagreement between the supply-side architects of the administration's growth strategy and the neoclassical economists who dominate the Fed and the economic establishment of the country.

Most mainstream economists believe that economic growth oscillates above and below a line of potential GDP, the latter determined by the growth rate of the workforce and productivity. Productivity is a by-product of innovation and technological discovery and largely exogenous of macro forces, or so the neoclassical thinking goes. For that reason most economic outlooks incorporate extrapolations of past productivity trends into the future. Productivity has been quite low over the past several years and most mainstream economists believe it will stay low. Robert Gordon's treatise on failing innovation offers the most detailed analysis on the topic; weak productivity lies at the core of the secular stagnation thesis championed by Larry Summers.

So it is largely from this perspective that the Fed's long-term economic projections show GDP growth converging to a trajectory of slightly less than 2%. By that standard, the current level of output is already close to or above this trajectory and the economy is growing unsustainably fast. Waiting to raise rates any longer only increases the odds of overheating and increases the downside of the eventual reversion back to trend. On top of all this, the enormous fiscal stimulus of the Trump budget at this stage of the expansion has left economists bug-eyed by the budget deficit projections. They are unprecedented for this stage of the cycle and double anywhere else in the Organization for Economic Cooperation and Development. Many look at this stimulus as a form of Keynesian pump priming. It is no surprise that Fed Chair Jerome Powell is more confident about the outlook than his predecessor—he has every reason to be.

The conventional perspective drives the supply siders in the White House crazy. Supply-side theory argues that growth drives productivity, not the other way around. Productivity is endogenous to the pace of expansion and stems directly from net expansions to the capital stock of a nation, is the argument. Correspondingly, the administration's policy of corporate tax cuts is designed specifically to encourage business investment, which will boost the capital stock, and ultimately, productivity. The eye-popping budget deficits won't happen if the Fed gives the growth process a chance, especially since inflation remains low.

There is some academic research1 to support the White House view and it is provided by the Fed itself. Two Fed staff economists in a working paper document how tax cuts in the post-1980s era have been associated with lower equity returns in spite of higher cash flows because of the effect on discount rates caused by a more restrictive Fed. This is still not hard counter-factual evidence but it does suggest that Fed reactions to fiscal stimulus have tended to smother the beneficial growth effects of past stimulative measures.

The policy debate is hardly academic. The threat of the Fed robbing the administration of success is a movie that many of the supply siders in the White House believe they have seen before. Kudlow and other supply siders believe it was the hard money attitude of the Volcker Fed and the resulting surge in the U.S. dollar during the Reagan era that undermined the potential growth path of U.S. GDP and led to the yawning deficits of that era instead of better productivity and faster non-inflationary growth.

President Trump seems wary of this mechanism playing out again:

"I don't like all this work that goes into what we are doing…you look at the euro, you look at what is going on with the EU…they are not doing what we are doing…and we already have somewhat of a disadvantage…last year and for years we have been losing $150 billion with EU nations…they are making money easy and their currency is falling and China their currency is dropping like a rock and our currency is going up and I have to tell you it puts us at a disadvantage… I don't like all this work we are putting into this economy and then I see rates going up."

One thing is for sure. President Trump is never shy to express his displeasure. Sustaining rapid economic growth is the foundation of his presidency. Any action that undermines this outcome will get his attention and incur his wrath. Many variables seem to have reached a crucial fork in the road. Nominal GDP growth broke out above post-2008 highs for the first time in the second quarter. The Fed has sounded more hawkish all year and the speed of balance sheet tightening is picking up. In the meantime, the dollar is at a significant level. Whatever the future of Fed independence, Trump's recent criticism was probably just the opening salvo.

 


1 See, for example, Diercks, Anthony M. and Waller, William, Taxes and the Fed: Theory and Evidence from Equities (2017-10-11). FEDS Working Paper No. 2017-104. Available at SSRN: https://ssrn.com/abstract=3052177 or http://dx.doi.org/10.17016/FEDS.2017.104

 

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK & Switzerland) this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority.

In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.

Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information Documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.