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Who’s right about the economy: Trump or the Federal Reserve?

The Fed is widely expected to hike interest rates Wednesday, but it faces a big test in 2019.

Fed Chairman Jerome H. Powell was asked Dec. 19 about the impact of President Trump's tweets on the markets and financial conditions. (Video: Reuters)

Federal Reserve Chair Jerome H. Powell faces the biggest test of his young tenure Wednesday as he tries to reassure the nation that the U.S. central bank has a firm grip on the state of the economy – and won’t do anything to up the odds of a recession in the next year or two.

The Fed is expected to hike rates another quarter-point – its fourth hike this year – but the real question is what language the Fed and Powell use to hint at what they think will happen next year.

A big selloff in financial markets has shifted the ground quickly for Powell, who only recently was projecting strong confidence that the economy would continue to grow smoothly for the foreseeable future. Such moments are often perilous for Fed chairs, who prefer to focus on the long-term growth of the economy and not temporary volatility in markets.

Powell has been trying to convince Americans that his team can engineer a Goldilocks economy — plentiful jobs, low inflation and solid growth without overheating — a rare scenario that hasn’t happened since the 1990s. His biggest concern this year has been ensuring the economy won’t overheat now that unemployment is near a 50-year low and growth is robust.

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But he has been facing intense pressure from President Trump, who’s been complaining that Powell’s efforts to raise rates were causing the market sell-off. The Dow Jones industrial average has fallen 10 percent from its September peak, wiping out all gains for the year and setting up the Dow for its worst annual performance since 2008. Other markets, especially high-yield debt, are also showing signs of stress.

Trump is already setting up Powell to take the blame if a recession hits in 2020. The president tweeted twice this week that it would be “a mistake” for the Fed to raise interest rates again, and he has repeatedly called the central bank “foolish” and “crazy.”

President Trump said Oct. 10, 2018 that that the Federal Reserve, which has been raising interest rates, has "gone crazy." (Video: Reuters)

Powell faces a tricky situation Wednesday. Hiking interest rates and using language suggesting a lot more hikes in the future could send markets plunging. But suggestions the Fed could significantly pare back its efforts to hike rates could serve to confirm fears that the economy is stumbling. And not raising rates at all might seem like the Fed is bending to Trump’s will, threatening its credibility.

Economists surveyed by The Washington Post overwhelmingly think Powell is right to raise the benchmark U.S. interest rate Wednesday to a range of 2.25 to 2.5 percent. Twenty-seven out of the 32 surveyed said the economy is strong enough to handle a more “normal” interest rate that is closer to 3 percent. But they also pointed out that the Fed boxed itself into a corner this time, and it can’t make that mistake again.

"If there is no hike, markets will conclude that the Fed is scared of the president or any correction in the stock market, or both,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. “Credibility takes years to build and minutes to lose.”

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Powell will need more flexibility in 2019, especially if headwinds keep getting stronger. The Chinese and European economies are slowing, stock and bond markets are jittery, Trump’s trade war is starting to hurt and the boost from Trump’s tax cuts is widely expected to diminish next year.

“Over the past few months it’s become clear that the Fed’s communication strategy has failed pretty badly,” said Ed Al-Hussainy, a senior interest rate and currency analyst at Columbia Threadneedle. “The Fed miscommunicated their confidence in the strength of the economy.”

In September, the Fed projected it would raise interest rates this month and then three more times in 2019. Today Wall Street traders are barely pricing in one interest rate hike next year, a dramatically more pessimistic outlook.

Powell has tried to build in more flexibility next year by announcing that he will give a news conference after all eight meetings, something that hasn’t been done before and allows the Fed more options to act — or hold off — on interest rate hikes as it deems necessary.

Few experts predict a recession next year, but whether the U.S. economy slows a lot or a little will depend, in part, on the Fed and Trump’s trade war.

Growth is hovering around 3 percent this year and estimates for next year vary from around 1.5 percent to nearly 3 percent.

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“The best outcome Wednesday is a dovish hike, where they move next year’s rate hike expectations from three to two,” said Tendayi Kapfidze, chief economist at LendingTree.

If the central bank raises interest rates too quickly in 2019, it will dry up business and consumer spending. The housing and auto markets, two sectors that are highly sensitive to interest rates, have already slowed noticeably.

“The Fed is risking a chance of a recession by unnecessarily putting the housing market into a decline,” said Lawrence Yun, chief economist at the National Association of Realtors. He noted inflation, a key concern of the Fed, is highly unlikely to shoot up in 2019 now that oil prices are falling and home price growth is slowing.

The Fed is struggling to know how quickly to react to the rapidly changing market and sentiment data. Its job is not to keep the stock market happy, but its mandate is to keep unemployment low and prices stable, and if the growing unease in the stock market causes business and consumers to pull back on spending early next year, it could be a rough time in the economy.

Reading economic and market signals correctly is extremely tough. Former Fed chair Alan Greenspan famously said in 1996 that the market was exhibiting “irrational exuberance.” The dot-com bubble didn’t start bursting until 2000.

In September 2008, a day after Lehman Brothers declared bankruptcy, the Fed met and kept interest rates the same because they didn’t see great risks. Chair Ben Bernanke summed up the sentiment around the table when he said, “I believe that our current funds rate setting is appropriate, and I don’t really see any reason to change.” By the end of that year, the Fed took unprecedented steps to cut interest rates to zero to try to revive the economy and get the country out of a deep financial crisis.

More recently, former Fed chair Janet Yellen resisted pressure to hike interest rates in 2014 and much of 2015, arguing that inflation wasn’t a problem and the job market had a lot more room to recover. That calls appears to have been right, although some experts like David Beckworth, a senior fellow at the Mercatus Center, question whether Yellen should have done even the one interest rate hike in December 2015.

Once again, opinions vary widely about what’s causing the unease in the markets now and whether the Fed should worry about it.

“The stock market is an important leading economic indicator, but we think the crazy volatility is more a reflection of the chaos down in Washington. which has investors chasing their tails or tweets too much,” said Chris Rupkey, chief financial economist at MUFG Union Bank.

It’s a tricky time for the Fed, economists say, as central bank leaders claim to be “data dependent,” but the available data is sending mixed signals.

“The Fed’s credibility is on the line,” said Andrew Levin, a Dartmouth professor and former Fed economist. “What market is looking for is real clear signal of what the Fed’s thinking is and what their strategy is for the coming year.”