This is a story about two things: how strong the economy is, and how worried the Fed is this might eventually turn into either a bubble or higher inflation.
The easiest way to think about this is that, if the economy were a car traveling downhill, the Fed’s job is to keep it moving at a responsible 55 miles per hour by stepping on and off the brakes as needed. This might sound simple, but, as former Fed chair Ben Bernanke pointed out back in 2004, the reality is a lot more complicated. There are a couple reasons for this. First off, the economy doesn’t have the most reliable speedometer. The Fed can get an idea of how fast (or slow) it’s been moving when the jobs numbers come out every month, and the gross domestic product ones do every quarter.
But it’s only that: an idea. These numbers can be pretty volatile, and they’re subject to quite a bit of revision. Which means they’re not always the best real-time guide to policy. Not to mention that it can take the economy a while to react when the Fed does raise or lower rates. So it can also be hard to tell whether it needs to do more, or just wait for what it already did to take effect.
Then, to continue the analogy, there’s the question of how steep the hill is. If it has a pretty good gradient, then it’d be easier for lower unemployment to turn into higher inflation, so the Fed would have to step on the brakes harder once the economy did get going. If it didn’t, though, the Fed could afford to be much more patient, since there’d be little risk that our economic car would careen out of control. But, once again, the problem here is that this isn’t something the Fed can observe directly. It can only be guessed at based on recent experience.
Now, ever since the 2008 crisis, the Fed has thought that the economy would be growing much less than before, and the metaphorical hill we talked about would be so flat as to almost be nonexistent. As a result, it’s suggested that it would only barely need to tap the brakes even far into the future. Indeed, it estimated that just raising rates to 3 percent would be enough to get them up to the Goldilocks zone where they were neither slowing down nor speeding up the economy. That had been 5 or 6 or even 7 percent as recently as 10 years ago.
So if you thought that growth was going to be so low that the Fed wouldn’t want to subtract too much from it, it made sense to assume that it would raise rates to somewhere around that neutral rate of 3 percent, and then stop. Well, at least it did until a few weeks ago. Since then, though, Fed Chair Jerome H. Powell has said that rates are still “a long way from neutral, probably,” and a few of his colleagues have pushed to raise them beyond that level, whatever it is. In the most dovish case, then, things might end up being more hawkish than we thought. It’s possible that rates get up to 3.5 or 4 percent in the next two years or so. What’s changed? Pretty simple: The $1.8 trillion of stimulus the Trump administration has pumped into the economy has sped things up enough that, even if our economic car is moving down a very slight slope, the Fed is worried we might start to go a little too fast. In that case, it’s understandable that they might want to ride the brakes a little bit more.
At the same time, Trump makes a very sound point when he says it’d be better not to hit the brakes until the economy actually does start to go too fast — for example, when inflation is actually above its 2 percent target — rather than doing so preemptively. He’s just going about this in a very unsound manner, publicly pressuring the Fed in a way that seems to implicitly threaten its independence. (The reason this has generally been considered verboten is that a president always has a political incentive to push for lower interest rates, even if there’s not an economic reason for them).
Trump, then, has good reasons for thinking that the Fed is raising rates more than the economic situation warrants, but so does the Fed for thinking that it’s raising them as much as the situation might if things don’t go as planned. What makes this even more intractable is that the more Trump criticizes, the more the Fed might feel like it has to keep doing what it has been, in part, to show that it can.
The Fed is going to be driving Trump crazy for a while.