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Economy in Brief

Politics Invades Fed Policy: A Replay of the 1970s?
by Joseph G. Carson ([email protected])  April 5, 2019

The Fed has a problem; politics has invaded its policy turf. Criticism by President Trump over the Federal Reserve decisions to hike official rates has now escalated to an even higher level as the Administration's top economic advisor says the Fed should lower official rates by 50 basis points. That complicates the Fed's decision-making process because there is a higher political bar to meet in order to justify rate increases.

This is not the first time politics attempted to influence the Fed. In the 1970s President Nixon pressured his newly installed Fed Chair, Arthur Burns to keep rates low to promote growth. President Nixon is quoted as saying, "We'll take inflation if necessary, but we can't take unemployment." One could argue President Trump is saying something similar with a slight twist-- "We'll take inflation if necessary, but we can't take lower stock prices."

With the potential appointments of two vocal supporters of the President to the Federal Reserve Board political interference in monetary policy is the most overt since the 1970s. All of this comes at a time when the Federal Reserve responsibilities and roles have expanded far beyond its role of a traditional manager of monetary policy. The new roles, especially its increased involvement in the financial markets, requires a precarious balancing act because policy decisions based on its economic mandates may at times conflict with its role on maintaining financial stability, making the Fed's more vulnerable to second-guessing and political criticism.

The economic and financial events as well as the policy decisions of the past several months underscore how difficult it is to manage expectations of various stakeholders, keep conditions calm, avoid criticism while fulfilling its various roles.

At the September 25-26 Federal Open Market Committee (FOMC) meeting, with a strong economy, tight labor markets and inflation near its target policymakers decided to raise official rates 25 basis points, lifting official rates above the relatively low 2% threshold for the first time in over a decade. At the same time, policymakers confidently laid out a credible case for another 25 basis points increase by the year-end and three more modest increases in 2019, lifting official rates to a little over 3%, if all things went according to plan.

Policymaker's plans were quickly criticized on several fronts as it came at time when there were mounting concerns about a sharp slowdown in global growth. Financial markets soon became unsettled with sharp spikes in volatility and big declines in equity prices, along with a collapse in bond yields. At its deepest point in December equity prices had dropped nearly 20% in a span of less than three months.

The economic fallout from the sharp plunge in the equity markets has been glossed over, but it shouldn't be. As the equity market decline gain speed, especially in December, consumers quickly pulled back on spending. Nominal retail sales plunged 1.6% in December, a stunning decline on its own, but it's even more alarming when one realizes it actually exceeded the 1.5% decline of September 2008, the month in which Lehman defaulted and payrolls fell 460,000.

All of this illustrates the difficult balancing act policymakers face as they roll back the easy money policies of the past several years. Easy money has more friends than enemies and yet easy money is not the appropriate policy stance today as it has the potential to inflate asset prices to the point of risking greater financial instability even more so than what occurred in the fourth quarter of 2018.

It's hard to predict what happens next, but given the strength in labor markets and strong rebound in equity prices in Q1, which almost recouped all the declines of the fourth quarter, a credible case can be made that the next move in official rates is up, and not down as the President team demanded. Yet, to the extent the "politics" of today imposes any restraint on policymakers fulfilling all of its peculiar roles will only increase the risk of a bad economic outcome at some point, similar to what happen in the 1970s when politics invaded Fed policy. Today the risks center on financial stability and the last two downturns have demonstrated how destabilizing imbalances in asset markets can wreck as much harm on the economy as the high inflation of the 1970s.

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