What should the Fed do?
Battling inflation and low growth will not be easy
Everyone saw it coming. After single-handedly roiling financial markets and harming America’s economy, President Trump is looking for someone to blame. Today, that someone was Jerome Powell, chair of the Federal Reserve. Posting on Truth Social, President Trump said on the morning of April 17th:
The ECB is expected to cut interest rates for the 7th time, and yet, “Too Late” Jerome Powell of the Fed, who is always TOO LATE AND WRONG, yesterday issued a report which was another, and typical, complete “mess!” Oil prices are down, groceries (even eggs!) are down, and the USA is getting RICH ON TARIFFS. Too Late should have lowered Interest Rates, like the ECB, long ago, but he should certainly lower them now. Powell’s termination cannot come fast enough!
It’s worth noting that Jerome Powell was first appointed by Trump in 2018. He was reappointed by Joe Biden in 2022, and his current term will expire in 2026. There’s a lot wrong with Trump’s Truth Social post, not least that the ECB (European Central Bank) was expected to cut interest rates for the first time, not the seventh. It’s also important the Fed chair doesn’t bow to the whims of the president and maintains independence. That later issue is a topic for another day. This post will focus on Trump’s request for the Fed to lower rates.
First, a quick review. The Fed is tasked with two goals by Congress. First, promoting maximum employment. Second, promoting stable prices. It has several mechanisms to achieve these goals, but the most powerful by far is its control over interest rates. The Fed sets the rate at which it lends money to banks, as well as how much banks are paid for keeping cash reserves on hand. This influences all other lending rates, from loans that banks give each other, to the loans banks provide to businesses, to the mortgages banks issue to individual homebuyers. In general, a low interest rate results in a stronger economy and higher employment but also higher prices. A high interest rate causes a weaker economy and lower employment but also lower prices. The Fed is essentially stuck in an Odyssian trap, except instead of having to pilot the Argo between Scylla and Charybdis the Fed must constantly balance economic growth with inflation. Set rates too low, and the economy with overheat and cause inflation. Set rates too high, and prices will stay low but the economy will suffer and unemployment will rise.
Trump is far from the president to put pressure on the Fed to forget about inflation and instead focus solely on growth; although as per usual his methods are far more explicit than previous occupants of the Oval Office. Luckily, the Fed is insulated from political pressure. At least in theory, the president cannot fire the Chair of the Fed and Powell will stay in charge until his term runs out in 2026. Beyond the political concerns about a President openly threatening to “terminate” the Fed Chair, Trump’s demands are economically dubious for several reasons.
First, it is true that shortly after Trump’s Truth Social post, the ECB did lower the target interest rate for the Euro by a quarter point, the first decrease since 2019. That said, the decisions of the ECB and the Fed do not have to mirror one another. Both organizations have the same responsibility; to balance employment and inflation. However, the economic outlook in Europe and the US are not the same. The US currently has a strong economy with elevated inflation. GDP has grown a respectable 2.5 percent compared to last year, unemployment is at a low (albeit increasing) 4.2 percent, and inflation is at an elevated but reasonable 2.8 percent. Given that GDP growth is fine, unemployment is low, but inflation is above the Fed’s 2.0 percent target, it makes sense for the Fed to not lower rates. Europe, on the other hand, has a weaker economy and lower inflation. In the Euro area, GDP growth is a dismal 1.2 percent, unemployment at 6.1 percent, and inflation at 2.2 percent. Thus, for Europe, a little extra stimulus is warranted. It will be better for the Eurozone to lower unemployment even if that means increasing inflation.
Second, accusing the Fed of overly focusing on inflation and keeping rates too high is laughable. For the last few years, the Fed has strongly prioritized high employment over low inflation. In February of 2021 inflation was below target at 1.7 percent. By June of 2021 it had skyrocketed to 5.3 percent. And yet the Fed did not raise rates. By December of 2021 inflation topped 7.1 percent, the highest in 30 years. Still, the Fed did not act. Some economists, such as Larry Summers, were shouting from the rooftops that this was a major problem and it needed to be addressed immediately. Others, like Paul Krugman, insisted that inflation was transitory and the Fed should let things play out. The Fed sided with the latter camp, to the long-term detriment of the economy. It wasn’t until March of 2022 that the Fed raised rates, and inflation would not dip below 3.0 percent until July of 2024. Any accusation that the Fed is leaving rates too high flies in the face of recent history.
Third, there is a subjectivity to when employment should be the priority versus when the focus should be on inflation. If unemployment is at record lows and inflation is the highest in decades, as was the case in 2022, then clearly the Fed should raise rates and lower inflation, even if that means increasing unemployment. If unemployment is at 10.0 percent and inflation is negative, as was briefly the case in 2009, then the Fed should keep rates low. Those are both clear-cut cases. When there is pressure on both employment and inflation, things become more of a judgement call. What will do more long-term harm to the economy, inflation or unemployment? How is harm even defined? How do we weigh unemployment for the few versus higher prices for the many? There aren’t objective answers to these questions.
Fourth, and perhaps most importantly, the Fed is not the only player here. If the government is worried about economic growth or inflation, it has tools as well. If Congress or the President is worried about inflation, the solution is economically simple but politically impossible. Lower the deficit. Cut spending, raise taxes, or some combination of the two. If Congress or the President is worried about employment, the solution is economically simple and politically easy: get rid of the tariffs. Revert things to how they were in 2016. Better yet, set almost all tariff rates at zero and stop the madness entirely. That would increase employment and grow the economy. As long as the executive and legislative branches of government has an easy path to economic growth, the Fed should focus more on inflation.
The world will be watching to see what happens next. The next Fed meeting regarding interest rates will be in early May. Powell has stressed the Fed’s independence and has generally taken a deliberate approach before changing rates. One group predicts the Fed will leave rates unchanged in May with an 87.7 percent probability. If that happens, Trump will be furious, but it’s probably the right call. We shall see.