Over the last few weeks, the Federal Reserve has come under criticism from Mr. Trump, the Republican presidential nominee. Although Mr. Trump is not known for his policy or economic expertise, he claims that the Fed’s refusal to raise interest rates is motivated by political considerations, bemoaning that the Fed “made the political decision every single time.” In Fed Governor Lael Brainard’s speech The New Normal and What It Means For Monetary Policy, she provides more than enough evidence that the Federal Reserve is in fact acting in the interest of both the US and global economy.
In particular, Governor Brainard correctly points out that the policy tools the Fed has at its disposal are asymmetric with the federal funds rate so low; here are her exact words,
“In today’s new normal, the costs to the economy of greater-than-expected strength in demand are likely to be lower than the costs of significant unexpected weakness. In the case of unexpected strength, we have well-tried and tested tools and ample policy space in which to react. Moreover, because of Phillips curve flattening, the possibility of remaining labor market slack, the likely substantial response of the exchange rate and its depressing effect on inflation, the low neutral rate, and the fact that inflation expectations are well anchored to the upside, the response of inflation to unexpected strength in demand will likely be modest and gradual, requiring a correspondingly moderate policy response and implying relatively slight costs to the economy. In the face of an adverse shock, however, our conventional policy toolkit is more limited, and thus the risk of being unable to adequately respond to unexpected weakness is greater.”
In other words, Gov. Brainard is saying that the Federal Reserve is highly susceptible to a new recession. Because interest rates are low, one might worry about inflationary pressures (though that has yet to be an issue, with inflation at around 1%). That is why some (Mr. Trump included) want the Fed to raise rates. However, Gov. Brainard is arguing that the Fed is well-equipped to deal with rising inflation. On the other hand, because rates are already so low, there are potentially grave risks associated with increasing the federal funds rate. Specifically, the economy may tighten too much leading to a recession, but the Fed will be unable to effectively combat that recession by lowering interest rates since they are already so low. Let’s delve deeper into the two sides, to get a more nuanced understanding of the argument.
The potential issue with a “greater-than-expected strength in demand” (think consumers suddenly buying more goods, because the cost of borrowing is so low) is rising inflation, which Brainard explains may be tempered as a result of a variety of conditions, including:
- The flattening of the Phillips Curve, meaning if GDP goes over its natural rate (as it might with stronger demand than expected), the rate at which inflation increases will be subdued (relative to the past)
- The slackness of the labor market, so that GDP may still be below its natural rate (not at full capacity yet, essentially) so a strong demand increase would not have as large an impact on inflation.
Because of these and the other listed factors in the article, the Fed is not too preoccupied by the possibility of unexpectedly strong demand. Moreover, if such a shock were to occur and increase inflationary pressures by too much, the Fed’s most likely response – tightening the monetary reigns by increasing rates – is still very much in play. All this to say, keeping rates too low for too long is not a big deal, as a surge in demand can be managed with relative ease.
On the flip side, Gov. Brainard admits that “In the face of an adverse shock, however, our conventional policy toolkit is more limited, and thus the risk of being unable to adequately respond to unexpected weakness is greater.” If the Fed raised the rates – acting as Mr. Trump and others have suggested – demand in the economy would naturally tighten (the cost of borrowing is now higher, so people will tend to save more if the rates increase). If the economy tightens too much, a recession will follow. The most effective way for the Fed to fight recessions using monetary policy is to lower the interest rates. However, since the rates are already so close to zero, the Fed will not have much room to act, thereby leaving it relatively incapable of handling an adverse shock in demand. Thus, the cost of increasing the rates is in part the risk of causing a hard-to-fight recession.
Based on this analysis, it’s evident that the precautionary strategy of slowly raising rates is economically well-founded. So next time you hear Mr. Trump say that the Fed is acting purely politically, ignore him.
Thanks to Alex Weiss for discussing the speech with me, and providing valuable intuition.