The Fed Has A Problem: Politics Invades Policy

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 the economic case for policymakers to resume hiking official rates is very compelling today, but there is now a higher political bar to meet in order to justify rate increases.

It's often been said that "when the next recession arrives, you will find written on its bottom, 'Made in Washington' ", as policymakers have repeatedly failed to take corrective steps to avoid destabilizing imbalances forming in the economy and financial markets. Yet, the next downturn could very well have a different label, 'Made in the White House', since political interference may impede the Fed from doing its job in a timely manner.

The Federal Reserve responsibilities have expanded far beyond its traditional role as the manager of monetary policy. The Fed has become the seer on the economy, arbiter on inflation, supporter of employment, a guardian of investors and an investor, active regulator and overseer of financial stability.

As the Fed's role and reach has expanded its vulnerability has grown because these peculiar roles require, at various times, conflicting policies creating a precarious balancing act, opening up policymakers for second-guessing, internal disagreements and political interference. All of these played a role in the flip-flopping decisions of the Fed in the past 6 months.

At the September 25-26 Federal Open Market Committee (FOMC) meeting 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 laid out a credible case for further modest increases in official rates to a little over 3% by the end of 2019 based on continued modest growth in the economy, tight labor markets and inflation at or near target.

Yet, policymaker's plans were quickly challenged by a near 20% drop in the equity market in Q4, loud and constant criticism by the President on the Fed's chair decision to raise rates, worries and uncertainty about the economic impact from the government shutdown and US-China trade war, second-guessing on the need for additional rate hikes from a number of investors and financial market participants, and even some internal disagreements over what constitutes a neutral rate policy. In March, policymakers made a surprising change to policy guidance as they removed any additional rate hikes from their forecast for 2019, and in the process adopted a "data dependent policy" approach.

In the 6 months since the September FOMC meeting payroll employment growth has averaged a relatively strong 207,000 per month, the jobless rate is little changed (3.7% to 3.8% today) and so too is core inflation (2.2% to 2.1%), while the equity markets have gained back almost of the lost ground and are within a few percent of matching their all time highs.

Its unclear what "data dependent" means, but faced with basically the same economic and financial conditions that were in place at the time of September FOMC meeting a credible case can be made policymakers should soon revisit their original plans of hiking official rates in a modest manner in order to prevent imbalances developing in the real economy and financial markets.

It is hard to predict what happens next, but the real danger is that politics will compel policymakers to keep easy money conditions in place longer than is justified by the fundamentals creating asset price imbalances that will eventually threaten the business cycle at some point. In the run-up to the past two recessions, policymakers largely ignored destabilizing imbalances in the financial markets and yet this time politics may limit their ability to act preemptively.

Given all of the various roles the Fed plays today it is virtually impossible to manage expectations of the various stakeholder groups, keep conditions calm while avoiding criticism. Policymakers will always be second-guessed, but in order to retain its autonomy and credibility policymakers need to block out the "noise" and "criticism".

That will be hard to do because the "politics" of today calls for lower rates, while the underlying "economics" at some point may call for higher rates. And every step policymakers take towards fulfilling it traditional role of managing monetary policy will only intensive the political pressure raising doubts and questions about the continued independence of the Fed.