The Federal Reserve effectiveness is unjustifiably tested by President Trump, who blames data-dependent monetary policy for a stronger dollar rather than a strong U.S. economy, record low unemployment and a bond bias, driven by concerns of a slowing global economy as well as the U.S. – China trade and technology war. The latter exacerbated dollar strength following the Treasury’s decision to impose 25% and 10% tariffs on 250 billion and 300 billion worth of Chinese products spanning transport equipment, apparel and U.S. technological products.
The Chinese economy, whilst important to U.S. technology supply chains, is also more exposed to trade tensions in the near term as Huawei, for example, is a major buyer of chips and semiconductors. The IMF’s most recent World Economic Outlook saw a 0.3% upward revision to 2.6% and a slight downward revision to China’s economic outlook for 2019 to 6.2% from 6.3% previously. This further underpins the dollar strength, in addition to its haven properties during periods of sustained economic uncertainty.
The Fed policy is accurate, so far
The Federal Reserve lowered interest rates by 25 bps to 2.25% in June, in other to support the economic expansion currently at its 11th year, with record-low unemployment and rising wages. The decision to lower interest rates is not a precursor for further easing but rather supports the FED’s mandate of maximum employment and 2.0% inflation target. Despite being castigated by the U.S. president, the Fed’s policy is designed to achieve its mandate and support the current expansion rather than justify President Trump’s trade war.
Figure 1: The relationship between domestic investment and lower interest rates might be tested due to the trade war
The recent rate cut coincided with U.S. tariffs on Chinese products, but this will likely improve financial conditions and sentiment rather than boost business investment, which has fallen following the uncertainty posed by the U.S. – China trade war. As illustrated in the chart below, business investment rose significantly after the FED cut interest rates in other to stimulate the economy following the 2007-2008 recession. Not only did domestic investment firm, the additional stock – net private domestic investment – rose more markedly, suggesting a greater rate of pass-through from policy rates to business investments. The brief downturn in 2015 followed the Fed’s decision to raise interest rates from 0.5% in Dec 2017 to 2.25% in Dec 2019 i.e. 9 times since 2015.
Sentiment appears to be more relevant in the near-term
Despite being in its 11th year of expansion, the U.S. economy – especially stock indices – appear to be driven by market sentiment, driven by trade policy. The recent corrections in U.S. stock indices are somewhat justified as Technology stocks and chip makers are exposed to both Chinese supply chains and demand in the near term. Although below-target inflation justifies a more accommodative stance, the signaling-mechanism will likely negate the adverse impacts from trade and geopolitical uncertainty somewhat. It is, however, important that the FED remains on hold until more clarity emerges on U.S. trade policy as further rate cuts will only serve to embolden current U.S. trade policy. Pre-emptive cuts will likely increase financial stability risks rather than incentivize investments in riskier assets as uncertainty bodes ill for long-term capital spending. Cutting interest rates further will be counterproductive, as it will provide ammunition for the Trump administration to heighten rather than de-escalate the trade war.
This is ill-advised for two reasons.
- Cutting interest rates will not achieve the 2.0% inflation target as weaker consumer confidence will cause them to postpone consumption, especially for Autos. Even as higher prices could momentarily push inflation higher, lower demand could temper any excesses in price growth.
- Lower interest rates will also exacerbate corporate debt levels. It might easy to understate the implications for financial stability risk as low-interest rates have reduced the cost of capital but increased leverage in the household and corporate sector. Meanwhile, the 2018 tax cuts saw business investment rise even as share-buybacks caused asset prices and net worth to rise. The trade rhetoric was less pronounced then; at present, this lessens the effectiveness of any future rate cuts
Figure 2: Lowering interest rates could increase financial stability risk
At the height of the financial crisis, Non-financial corporate business and Non-financial corporate debt as a percentage of net worth and corporate equities stood at 53.5% and 40.6% (see chart). The Fed lowered interest rates by 500 bps by 2006, prompting a 19.7% and 2.7% fall in debt respectively by 2014. Lower interest rate improved debt servicing cost and help support the recovery and stimulate the economy. Despite staying well below pre-crisis highs, trade-driven cuts to interest rates could cause higher risk-taking from corporates; only this time, the Fed won’t be able to cut interest rates significantly, from already low levels of 2 – 2.25%, to support economic recovery in the event of a downturn.
The Fed could very well engage in a more aggressive bond purchase program to improve the corporate balance sheet and improve the growth-causing effects of interest rates. However effective at improving the macroeconomic impacts of ultra-accommodative policy, this will equally increase the size of the FED balance sheet. The latter rose from 5.4% in 2006 to 22.7% in 2017. Some might overemphasize the attainment of the FED’s symmetric 2.0% inflation target, whilst ignoring the negating effect of the current U.S.- China trade war on waning supply-side drivers.
The trade war is having an unusual impact on the dollar
The dollar appreciated against most major currencies following the escalation in trade tensions, this caused renewed anxiety of a potential recession in an already slowing global economy, plagued by geopolitical uncertainty ranging from Brexit to Italy, to possible supply-side shocks from an escalation in the Strait of Hormuz – a choke point for global crude shipments.
U.S. crude production does no favors to inflation outcomes
Furthermore, the U.S. is now a net exporter of crude oil, with crude oil production rising by 12% to 12,072 million barrels from 10,783 million barrels a day. In other words, energy self-sufficiency, exacerbated by a stronger dollar will make the Feds job of attaining the inflation target much difficult even if they were to lower interest rates.
It is not only pragmatic, forward-looking and pre-emptive for the FED to begin balancing financial stability risk against the attainment of the inflation target vis-a-vis the trade war. The latter, whose impact has been felt by the technology sector and U.S. stock indices could quickly trickle into the real economy, causing unemployment to rise as companies seek to protect falling revenues from the trade war. The alternative will be a transient boost to inflation, which will nonetheless discourage consumer spending and reinforce the negative feedback loop from falling business confidence and investment
Trade uncertainty and its resulting effect on business confidence, not the cost of capital, explain falling business investment. In the event of a downturn, the Fed will have less room to engineer growth and support recovery. More urgent, is the need for monetary policy to move past its iron-clad insistence on an explicit inflation target, at least temporarily. However credible, an explicit inflation target and transparent communication strategy is the most effective way of smoothing business cycles and improving confidence in Central Bank monetary policy. One could, however, argue that a transient divergence from the attainment of the inflation target will reduce the risk of a policy-induced negative feedback loop; one that fails to support business investments and consumer demand should prices rise as a result of an escalation in the U.S. – China trade war.
Cutting interest rates could be economically counterproductive and is unlikely to achieve the Fed’s inflation target. Despite falling in recent months, inflation remains close to the Banks’ 2.0% target. If the price of a slight deviation from the Taylor rule is greater policy space to counter the next downturn, the FED must cease it. Markets and households might not understand a pause at present, but they will most certainly feel the benefits of a more forward-looking and innovative approach to monetary policy. A rate cut will justify the Trump administration’s approach to trade negotiations, and its impact on business investment will be tepid at best. Maintaining rather than depleting the current policy space isn’t an overriding objective of Fed policy, but it should at the very least inform its current thinking.