I have an extremely negative view of Trump and his policies. The current trade war with China is unnecessary and counterproductive. Trump’s fiscal policy is perhaps the most reckless in U.S. history. But let’s be honest about what causes downturns so we can be better at preventing them. Because Federal Reserve missteps often cause recessions, it is monetary policy that badly needs our attention.
Some economists have tried to develop models where “real shocks,” such as the trade war, create recessions. But these models have not proved successful. The U.S. economy is too large and diverse to be strongly affected by any individual sector. For instance, between January 2006 and April 2008, residential construction in America plunged by more than 50 percent, with very little impact on the overall unemployment rate. Then, in mid-2008, monetary policy became too contractionary when the Fed failed to cut rates quickly enough during the Great Recession. As a result, nominal GDP (the total dollar value of all spending on goods and services) starting falling. Now unemployment soared much higher as the problem spread beyond housing (6 percent of GDP at the peak of the boom) to many other sectors of the economy.
This is what distinguishes an actual recession from the problems in a specific sector of the economy. During a recession, there are job losses all across the economy, in a wide variety of industries. These losses occur because consumer and investment spending falls in an environment where nominal wages are “sticky” or slow to adjust. As in a game of musical chairs, a decline in spending leaves firms with less revenue to pay salaries, leaving some workers unemployed.
The Federal Reserve’s dual mandate calls for stable prices and high employment. The Fed generally tries to avoid recessions by ensuring that total spending in the economy grows fast enough to maintain full employment, without triggering high inflation. For the current U.S. economy, that means nominal GDP growth of about 4 percent per year, which allows inflation to stay near 2 percent. If there is a recession in 2020, it most likely will occur because the Fed has failed to cut interest rates quickly enough, pushing spending growth down far below 4 percent.
Trade with China is about 3 percent of GDP, and even with the current trade war, U.S. exports to China are likely to decline by about $25 billion this year, barely 0.1 percent of GDP. Unless the conflict intensifies dramatically, it is not a big enough factor to directly cause a recession. This is not to suggest that the current trade war doesn’t complicate the Fed’s job. Both the tariffs and the uncertainty about future tariffs have tended to slow business investment. This reduces the “equilibrium interest rate,” which is the rate that results in a stable economy. If the Fed doesn’t reduce its target interest rate in tandem with a falling equilibrium rate, a recession may result.
In standard economic models, tariffs lead to higher consumer prices. But markets are reacting to Trump’s tariff announcements as if traders view the effect as being deflationary. In other words, the opposite is happening. That’s because investors fear the Fed won’t cut its target interest rate as quickly as the decline in the equilibrium market interest rate. They worry monetary policy will become too contractionary for the needs of the economy.
Consider this analogy. You are on a ship from London, scheduled to arrive in New York. After three days, the captain announces that because of wind and waves, the ship is now expected to arrive in Boston, not New York. While it’s undeniable that wind and waves affect a ship, we should and do expect the captain to adjust the steering to offset the impact of these “real shocks.” Similarly, we should expect the Fed to adjust the money supply and interest rates to offset shocks caused by events like a trade war. In 2017 and 2018, the Fed appropriately offset the effect of an extremely expansionary fiscal policy by raising interest rates. Now it needs to offset the contractionary effect of the trade war by cutting them.
Unfortunately, monetary policy has become more complex in the 21st century, because of the “zero lower bound” problem. Central banks cannot cut interest rates much below zero, or perhaps minus 1 percent, because investors would simply choose to hold currency as an alternative. But the Fed has failed to adjust to this problem. Some economists suggest it should raise the inflation target as a way of keeping interest rates from falling below zero. This would be controversial, and the Fed’s reluctance is understandable. Less excusable is their willingness to allow inflation to fall below their 2 percent inflation target for most of the past decade. This pushes us closer to the zero bound for interest rates, which has recently made life difficult for policymakers in Europe and Japan.
More important, the Fed has failed to implement “level targeting,” which means promising to return to the original trend line for inflation, or better yet nominal GDP, after policy has temporarily gone off course. This sort of promise makes monetary policy much more powerful when rates are stuck at zero, by creating more bullish expectations among investors. Before joining the Fed, Ben Bernanke recommended that the Japanese consider level targeting, and prominent economists such as Christina Romer and Michael Woodford have suggested a similar concept for the United States. Fed officials are well aware of academic research on the zero bound problem and need to be held accountable if there is a recession because they failed to act.
Voters may ultimately decide that, no matter what consequences follow from Fed actions, the buck stops with Trump. He did, after all, appoint Fed chair Jerome Powell and several other top Fed officials. His trade war has made the Fed’s job more difficult. But there is an important reason to hold the Fed accountable for future recessions; it will make officials there more likely to take the steps required to prevent a recession from occurring.