According to our president, the nation’s central bank — the Federal Reserve — has gone “crazy.” For non-native speakers, he added “loco.” It has “gone wild,” it’s “out of control.”
First, let me assert, as I did recently on David Beckworth’s excellent Macro Musings podcast, that I don’t clutch my pearls and reach for the vapors whenever a politician, including the president, criticizes the Fed. I yield to no one in defense of the central bank’s political independence, a feature that is more vital now than ever. But elected officials represent millions of households whose living standards are significantly affected by Fed. The idea that they’re banned from talking about the bank’s policy decisions doesn’t make a lot of sense. That said, Fed officials have every right to tune them out and do the job they were appointed to do, which is precisely the view expressed by Fed Chairman Jay Powell in his last news conference when asked about Trump’s criticism.
Also, Trump is wrong. Far from crazy or out of control, in recent years the Fed has increasingly telegraphed its actions well in advance. Fed officials call it “forward guidance,” and it’s one of the ways they work with financial markets. In 2015, most Fed officials concluded that the U.S. economy no longer needed the stimulus of rates at zero, so they announced a long, slow, ongoing campaign to “normalize” their benchmark interest rate. That translates in about a quarter-point increase per quarter, with the current rate at 2.2 percent.
Higher interest rates — not just at the Fed but also at the Treasury, as yields on government bonds jumped sharply over the past week — are one of the reasons the stock market tanked earlier this week. Higher rates mean more expensive borrowing costs, and sensitive sectors, like housing — mortgage rates just hit a seven-year high — have already slowed.
Higher rates also strengthen the dollar, which can slow growth through fewer exports. The stronger dollar makes our exports more expensive relative to imports, and these price movements work like a weapon for the opposing army in the president’s trade war. Don’t tell President Trump, but our trade deficit with China is up significantly since he declared (trade) war (now there’s something to make him crazy). Foreign economies that borrowed in cheap dollars are now facing higher debt servicing costs as well, meaning contagion jitters are also in the mix.
So, amid all those moving parts, what explains the equity markets’ swoon earlier this week? Does the sell-off matter to the real economy? What effect will it have on jobs, wages and incomes?
There’s always the psychology of the herd involved in these sorts of moves, and what basically happened, at least as I see it, is that equity investors, like the frog in boiling water, suddenly awoke to risks. The U.S. economy is still strong and powering the corporate earnings that drive share prices, but it is likely to slow from here, especially once the fiscal stimulus starts to fade late next year.
Also, the spike in interest rates was a wake-up call to the markets that easy money doesn’t last forever. A simple truth is that the stock market has a surprisingly Keynesian heart, which warms to stimulus — monetary and fiscal — and chills with the removal of such accommodation.
By the way, there’s an interesting interaction with the tax cuts and other deficit spending that I haven’t seen mentioned in much of the analysis of the spike in Treasury yields. The most common explanations for the spike are the Fed’s increases and expectations of faster inflation (fixed income investors insist on higher yields if they fear inflation will erode their returns). But this mix also includes the sharp increase in borrowing by the federal government to finance all that debt it’s building up. Net borrowing this year is twice that of last year, and far above the Treasury’s usual demands when the economy is this close to full capacity. That increased supply of bonds puts downward pressure on their price and upward pressure on their yields.
Which brings us back to Trump. If he wants to see one big reason rates are up, both at the Fed and elsewhere, he should look in the mirror. When you add this much fiscal stimulus to an economy already closing in on full employment, you’re playing with, if not fire, then at least heat. In this regard, his Fed rants are his just usual operating procedure of finding someone to blame in case what he did goes wrong.
Thus far, heat hasn’t led to overheating, and I’ve been very glad to see the unemployment rate come down so far. To answer the question posed above, the stock market isn’t the real economy, and for now, strong demand is generating solid job growth, a lower unemployment rate and, finally, some real wage gains for middle-wage workers.
But the markets know there’s a recession out there somewhere. What if the Fed overreacts to the heat and moves from brake tapping to brake slamming? What if the trade war escalates? At least, that what they were worried about earlier this week. Today, it’s “Hey, whatever, let’s roll!”
So, look past the noise, don’t time the market, watch the real economy (jobs, wages, inflation) and when the president points fingers, look the other way.