Column: On interest rates, maybe Trump is right and the Fed is wrong

US President Donald J. Trump announces the nominee for Chair of the Board of Governors of the Federal Reserve System, Washington, USA - 02 Nov 2017
Not exactly what he had in mind: President Trump introduces Jerome Powell as his nominee for Federal Reserve chairman in November 2017.
(Michael Reynolds / EPA-EFE)

The battle between President Trump and Federal Reserve Chairman Jerome Powell over the Fed’s raising of interest rates has been almost universally depicted in Trumpian terms.

On one side, you have a petulant president trying to place the blame for a plunging stock market anywhere but on himself; on the other side, intelligent people trying to ignore him so they can do their jobs.

Treating this as a conflict of personalities is playing the game Trump’s way, a trap that the Washington press corps has been trying to wriggle out of for two years, without notable success. In this case, however, the narrative obscures a fundamental truth. Trump’s argument that the Fed has been raising short-term interest rates too aggressively is, in fact, backed by economists across the political and ideological spectrum.

I don’t see anything magical about targeting 2% inflation.
Former Fed Chairman Ben Bernanke

Take Brad DeLong of UC Berkeley, an economist who is least likely to be mistaken for a Trump acolyte. In a blog post Wednesday, DeLong dismisses almost all the arguments posed to justify the Fed’s rapid-fire rate hikes — four this year, with at least two more expected in 2019. As for defenses of the idea that the Fed needs to set rates higher now so it has more room to lower them to spur growth when the next recession hits, DeLong calls them “declarations of intellectual bankruptcy.”

DeLong argues that there’s no evidence that interest rates, although low, have been unsustainably low, and no plausible model for how raising rates now so they can be cut in the future makes economic sense. The argument, he says, resembles the argument that “you should let the others run a lap before you start running at all, because then you will be fresher and so can run faster and so win the race.”

Trump hasn’t placed his critique of Powell and the Fed in an economically sophisticated framework — he’s mostly done so via invective, calling the Fed’s policy “foolish” and “crazy” and “loco” and personalizing it as a fistfight between him and Powell, who happens to be his appointee as Fed chairman.

Some of the president’s critics attribute his stance to a search for a scapegoat for the stock market slump, which irks him because he spent nearly two years pointing to the surging market as evidence of the wisdom of his policies. (Even after Wednesday’s strong rebound, the Dow Jones industrial average and Standard & Poor’s 500 index are both down more than 7% for the year.)

Others place it in the vein of the blind squirrel or stopped clock phenomena — that is, a random hit on a good point.

But let’s take a look at how Trump and the economists managed to find common ground.

The principal critique of the Fed’s actions is related to its practice of “inflation targeting,” which means setting monetary policy to keep inflation within a given range. The critique isn’t of targeting per se but of the Fed’s particular target of 2% inflation, which economists increasingly feel is too restrictive. (The target is shared by most other major central banks.)

Among the virtues of inflation targeting, which has been in place more or less since the mid-1990s, is that it sends a clear signal to investors and business. Knowing the target enables them to anticipate Fed actions and also allows them to plan for a future in which inflation is held in check.

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Inflation has remained below 2% throughout most of the period since the 2008 recession (recessions are shown in gray). Is there reason to fear it now?
(Federal Reserve Bank of St. Louis)

But why 2%? “I don’t see anything magical about targeting 2% inflation,” Ben Bernanke, who was Fed chairman in 2012 when the target was publicly announced, has said. His advocacy of inflation targeting, he added, “was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target.”

The idea at the time was that a 2% target allowed for a bit of inflation, which is good, but not too much, which is bad. It was sufficiently remote from zero to protect against deflation, which is always bad.

But the tight 2% target may be prompting the Fed to tighten interest rates prematurely. The Fed’s concern is that as the economy heats up, and especially as it reaches full employment, inflation will soar. So it’s better to step on the brakes first.

But there’s plenty of evidence that slack remains in the labor market — job growth has been strong, but wages have barely increased above inflation, and millions of potential workers remain on the sidelines. And the consequences of the Fed’s tightening are beginning to look excessive, including emerging slowdowns in home construction, home buying and auto sales — sectors of the economy that are vulnerable to interest rate hikes because they’re dependent on credit.

The major flaw with the 2% target, economists say, is that it’s an anachronism. Deflation risks have increased, as former Treasury Secretary Lawrence Summers observed earlier this year. That alone would warrant giving inflation a bit more of a tailwind. Nor is there much evidence that inflation a bit higher than 2% would crimp economic growth.

As it happens, inflation (as measured by the Fed’s preferred metric, the personal consumption expenditure index) has remained lower than 2% during almost all of the period since the 2008 crash and recession. Some say that’s because successive Fed Chairs Bernanke and Janet Yellen kept a lid on interest rates.

But DeLong says that’s a misreading of the statistics, which show that “Bernanke and Yellen followed a declining neutral rate down, rather than pushed interest rates below neutral.” (The neutral rate is the rate when the economy is stable.)

That supports DeLong’s brief against another oft-heard argument for tightening interest rates now — that low interest rates foster the creation of asset bubbles, which can take down the economy when they pop. DeLong says that’s an argument against unsustainably low interest rates, not naturally low rates, which is what we’ve had under Bernanke and Yellen.

The emerging consensus among economists is that the appropriate Fed inflation target is 4%, not 2%. That would lift interest rates modestly, which would naturally give the Fed the headroom it seeks to address the next recession, without suppressing economic growth and thereby hastening the next recession.

The only problem with this argument is that economists don’t seem to feel that the Fed can raise its inflation target without generating criticism, particularly in Congress, that it’s abandoning its congressionally mandated commitment to “price stability.”

As it happens, Trump’s critique of the Fed doesn’t have the sophistication that’s needed in this debate — he doesn’t care about the inflation target, if he’s even aware there is one. He just wants the Fed to stop raising interest rates, which probably would lead to a breach of the 2% target.

This is the drawback of being right for the wrong reasons — it makes finding a solution to the problem at hand that much more difficult. The Fed’s choices are stark. It can keep raising rates, which would keep inflation within its target but anger Trump; or it can stop, which would please Trump but anger inflation hawks. Or it can come right out and say it’s reconsidering its target, which would please economists and create a new battleground for economic policy — but would demonstrate that it’s not just a collection of robots but an institution that knows that when conditions change, policy changes must follow.

“You can preserve a reputation for mulish stubbornness by being a stubborn mule that fails to process and react to new information,” DeLong writes. “But why would you want a reputation for mulish stubbornness that fails to process and react to new information?”

Jerome Powell may be wondering just now why he took his job.

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