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To what extent can Donald Trump change Federal Reserve interest rate policy?

17 August 2018

Since the time of President Theodore Roosevelt, US foreign policy has been to "speak softly and carry a big stick". Today, the approach is slightly different. 'Shout loudly and threaten' could potentially be a more accurate description. Whilst in the short-term this may achieve what appears to be a positive outcome, in the long run, it may result in the US having a declining influence in the world.

In the last ten days, we have seen the stability of the Turkish economy come under threat as US-Turkish relations deteriorated. Turkey is highly indebted and the Turkish Lira has been declining since the attempted coup and subsequent crack down on the opposition two years ago. When Trump put sanctions on officials to get a pastor released from custody, the currency decline became precipitous. Far from stepping in to help a NATO ally, he then hit them further with tariffs in steel and aluminium with the threat of more. Historically, diplomats would have been in a position to quietly resolve the situation, and a single citizen apparently caught up in a crackdown on the opposition would not have impacted the global financial markets. Today, the falls in the Turkish currency threaten their ability to repay their debt, which is largely held by European banks, causing ripples through the wider financial markets. 

President Trump has been critical of recent interest rate rises and complained that when he appointed Jay Powell as Chairman of the Federal Reserve ("Fed"), he thought he was an "easy money" guy. In the recent currency crisis, President Erdogan stopped the Turkish central bank from raising rates to defend the lira. In the US, the Fed is independent of politicians and therefore it is much harder to influence; even if Jay Powell wanted to stop raising rates, it is a committee decision. However, the President has an unusual opportunity at present, with four vacancies for Fed Governors to be filled.

The discussion of the role of the central bank in the US goes back to the founding fathers. Washington's Secretary of the Treasury, Alexander Hamilton (of the eponymous musical), proposed the first Bank of the United States. He identified the need for a bank to promote economic growth and stability, basing his idea on the Bank of England. Thomas Jefferson opposed this idea; he saw the future in farming and big business and disliked anything based on a British model. He also pointed out that the Constitution did not give Congress the power to form a bank and the suggestion that a central bank is unconstitutional has been repeated in the 21st century. The first bank had a twenty-year charter and opposition meant that the charter was not renewed. Some years later, a second bank was formed but this again did not last. The present Federal Reserve System was set up in 1913, again with a twenty-year charter but this was made permanent in 1927. The Federal Open Market Committee ("FOMC") that sets interest rates was established under the Banking Act of 1935. This said that the FOMC would be made up of the seven Board of Governors and the Reserve Bank Presidents, of which five can vote. The Treasury Fed Accord of 1951 and the Employment Act of 1946 established the Fed's independence and set goals for economic policy to "promote maximum employment, production and purchasing power". Today, this has been refined so that the aims of monetary policy are to promote price stability and maximum sustainable economic growth and employment. The Federal Reserve remains independent.

To protect the Fed from political interference, the governors are appointed for a fixed fourteen-year term, with one retiring every two years (the Chairman has a five-year term). This meant that change could only occur very gradually. However, if a governor retires early, then vacancies may be filled.  As noted above, there are four vacancies at the moment.  The President nominates candidates, but they must have the approval of Congress. The new candidates can expect close scrutiny. The Federal Reserve Presidents are appointed by the regional Federal reserves and are not political appointments. Therefore, Trump may nominate people he thinks will keep rates low but once appointed he cannot remove them. They may look at the economy and see reasons to raise rates as Jay Powell has done.

President Trump has claimed credit for the strong US economic growth and low unemployment. A buoyant economy with very low unemployment and low interest rates can lead to higher inflation that threatens future growth. Interest rates have been exceptionally low, so it has been prudent for the FOMC to gradually raise interest rates in line with its aim of sustainable economic growth. Raising rates now gives them the ability to cut again, should it become necessary. Trump's policy of tax cuts and spending are also boosting the economy, at a time when it was already doing well, giving further reasons for interest rates to go up. If Trump claims responsibility for the strong economy, then he may also be the inadvertent cause of rate rises. On the other side of the coin, the Fed has expressed concerns about Trump's trade tariffs causing a slowing of global economic growth. If this was to come through then it could see a slowing or end of rate rises.

To conclude, Trump is not able to directly dictate interest mate roves, however his position over fiscal and trade policies is able to affect the economy, therefore indirectly influencing interest rates. He may also have some impact on the composition of the FOMC, however the Fed remains independent and continues to react to economic circumstances rather than react to presidential rhetoric. It will stick to its objectives of price stability, maximum sustainable economic growth and employment. The Chairman of the Federal Reserve is speaking at Jackson Hole this afternoon and I expect he will confirm this view.

 

 

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