The worries begin with the extraordinary stimulus that’s beginning to be unleashed on the economy. At a time when gross domestic product is growing much faster than the Fed’s estimate of the sustainable rate, Trump’s tax cut and the recent budget deal are like gasoline on a bonfire. In the fourth quarter of 2017, the economy expanded at an annualized rate of 2.6 percent, almost 50 percent higher than the Fed’s guess of the speed limit. Wall Street forecasters expect the stimulus to drive this year’s growth up to around 3 percent
— and that builds in an assumption that the Fed will deliver on its stated intention to raise interest rates steadily.
Faced with the Trump stimulus, the Fed needs to accelerate its rate hikes commensurately. This is especially urgent because the Fed is starting from a position that is itself extremely stimulative. Nine years into the economic recovery, and with unemployment almost as low as it has been in nearly 50 years, the Fed’s short-term interest rate remains negative after accounting for inflation. Financial institutions are being paid to borrow. And although the Fed has begun to shed the bonds it accumulated as part of its post-crisis policy of quantitative easing, the stimulus from that easing is still very much present. Quantitative easing’s
effect comes from the stock of bonds, not from the flow of purchases or disposals. Because the stock remains high, quantitative easing continues to exert a sugary effect on the economy.
By the Fed’s own reckoning, it needs to deliver five additional quarter-point hikes just to get interest rates to “neutral” — the level at which policy is neither restraining growth nor boosting it. Because of the stimulus, Goldman Sachs predicts that the Fed may actually raise rates eight times over the the next two years to head off inflation.
The Trump team isn’t going to like this. No president wants the central bank to dampen growth, particularly not one who has dismissed chicken-little talk about the economic speed limit, and has boasted that 4 percent growth should be attainable. And a determined series of rate increases will not only restrain growth but also chill activity in ways that may be especially upsetting to the White House. Sectors of the economy that are sensitive to interest rates will be hit: think real estate. The dollar will probably strengthen, which would hurt the blue-collar manufacturing workers who helped to tip the election in Trump’s favor.
So the Fed and the administration are on a collision course. Paradoxically, a collision is especially likely because one part of the economics profession denies the danger. A dovish contingent argues that the Fed should allow the economy to run hot, and never mind the risk of inflation. This faction argues that cheaper imports and price-cutting tech companies will keep a lid on prices, and that, even though unemployment is extremely low, perhaps it could be driven lower still without bad side effects. This go-for-growth faction, more vocal than at any time since the 1970s, provides cover to Trump if he chooses to attack a hawkish Fed. It also makes it harder for the Fed to raise rates and still retain popular legitimacy.
All of which raises the specter of two bad outcomes. In the first, Trump loses patience with the Fed and lashes out, threatening the tradition of Fed independence that dates back to former chairmen Paul A. Volcker and Alan Greenspan. In the second, the Fed ducks its duty to accelerate the pace of rate increases, in which case either inflation or an asset bubble will threaten recession. A J.P. Morgan research team recently opined that “the new Fed chair, vetted by the current administration that uses the stock market as a score card, is highly unlikely to do anything to derail markets and the economic cycle.” If Powell vindicates this suspicion of timidity, the Fed will ultimately have to serve up more interest-rate increases to keep the economy from boiling over.
Of course, neither bad scenario is inevitable. Trump has handled the Fed more or less responsibly thus far — though he has been slow to fill vacancies in its leadership. If he lets it be known that he won’t interfere with monetary policy, ever, the damage from his budget policies may be mitigated.