Sebastian Mallaby is a Post contributor and Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations. He is the author of “The Man Who Knew: The Life and Times of Alan Greenspan.”
The election of Donald Trump threatens international institutions ranging from NAFTA to NATO. As far as domestic institutions are concerned, the Federal Reserve looks to be the most vulnerable. During the campaign, Trump demonstrated a willingness to attack the Fed and its leader in a way that no president or major-party nominee had done in a quarter-century. What’s more, the logic of his economic program is that he will end up bashing the Fed even more aggressively.
The president-elect says he wants to double the economy’s growth from 2 percent to 4 percent. To that end, he is promising big tax cuts combined with a splurge on infrastructure. This budget stimulus will pump up demand, which would be fine if supply grew commensurately. But there is a limit to how quickly the supply side of an economy can expand. If politicians create demand faster than companies can boost output, there will be too much money chasing too few goods — which is to say, inflation.
This problem is all the more acute because of Trump’s other promises. If he deports illegal immigrants, he will reduce the size of the workforce, cutting the economy’s supply capacity just as demand accelerates. If he lobs a protectionist grenade into the world trade system, he will disrupt manufacturers’ supply chains, damaging supply further. Trump may hope that deregulation and corporate tax cuts will encourage investment, allowing supply to catch up with demand. But corporate investment can take years to come on stream. And the uncertainty that Trump creates may smother it anyway.
How will the Federal Reserve respond to Trump’s program, assuming he actually implements it? Even before the election, the Fed was preparing to raise interest rates next month, as growth in the most recent quarter came in at 2.9 percent, above what is sustainable without inflation. Now, given Trump’s inflationary promises, the Fed will probably want to raise interest rates a lot more next year. Investors have already understood this prospect: Interest rates on long-term bonds have jumped recently.
Now comes the threat to the Fed as an institution. If the central bank does its job and raises interest rates, Trump isn’t going to like the consequences. Higher interest rates mean a stronger dollar, which will lure more migrant workers to the United States — legally if visas are available, illegally otherwise. Ironically, the likeliest source of migrants is Mexico. Trump’s promise to undo the North American Free Trade Agreement has already hit the Mexican peso, redoubling the incentive for Mexican laborers to go north, wall or no wall.
A strong dollar also means that U.S. exports will suffer and imports will jump, and Trump won’t like that either. The blue-collar workers who voted for him will lose out as manufacturing shifts to cheaper countries. During the campaign, Trump accused China of holding down the value of its currency to gain an unfair export boost — never mind the fact that China had recently intervened in the opposite direction. The irony is that Trump may relieve U.S. trade partners of the need to manipulate their currencies, because a strong dollar ensures that the United States is less competitive.
The stage is set, in other words, for a clash between the Fed and the new president. Inflation looks set to become a real worry for the first time in more than a decade, so the Fed will need to raise interest rates. That will make Trump’s promises look contradictory and foolish, so the president is likely to lash out at the central bankers. Having accused the Fed chair, Janet Yellen, of being in the pocket of the White House, Trump will switch to complaining that Yellen is too independent.
Clearly it is not too late to avoid this train wreck. Trump could dial back his budget stimulus and soften his stance on trade and immigration. But if he sticks to his promises and ends up in a fight with the central bank, he will find it easy to subjugate. Fed independence is not enshrined in law; it is a convention conjured into being by the Machiavellian genius of Alan Greenspan, who reigned over the central bank for almost two decades leading up to the financial crisis. Trump could go back to stacking the Fed’s board and bullying its leader with threats that her term will not be renewed — practices that were normal until the early 1990s. As it happens, two of the seven slots on the Fed’s board are vacant and Yellen’s term is up in January 2018, handing the president yet more leverage.
So Trump could get the central bank he wants. And if the result is a Fed that looks soft on inflation, expectations could feed upon themselves. Anticipating price rises, workers would demand more pay; anticipating pay rises, companies would force up prices: The economy would spiral back toward the stagflationary 1970s. It is too dark a prospect to believe. But the logic that takes us from here to there is chillingly straightforward.
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