The President Holds the Fed Chairman Prisoner

Yes, we wish it had been more vigorous. But longevity is nothing to sneer at. This month the current US economic expansion will be 10-years old, and by next month the longest on record. That compares with an average of less than five years for all post-WW2 expansions. During this expansion, the economy has added 20 million jobs and Americans have become $47 trillion richer.

Major forecasters are guessing that growth will continue, but that the days of 3.1% annual economic growth rates such as were recorded in the first quarter of this year are now behind us. The World Bank (2.5%), International Monetary Fund (2.6%), and a National Association of Business Economics’ (NABE) panel of 53 professional forecasters (2.6%) agree that the economy will cruise along at an acceptable speed for the rest of this year before slowing to about 2% or less in 2020. Of the major institutions only the Federal Reserve Board’s monetary policy committee does not expect the economy to manage growth of at least 2% this year — its number is 1.9%. Out of step, yes, but more important than the others since it is the Fed that sets monetary policy while other forecasters are heckling from the sidelines.

True, Fed forecasts undershoot reality with some regularity. But the Labor Department’s jobs report, released late last week, lends support to the Fed’s relative pessimism. In May the economy added a mere 75,000 new jobs, well below April’s 263,000 and the 164,000 average so far this year. That weak report adds to indications from key sectors of the economy that the 10-year-old recovery’s prospect of reaching its teens is not assured.

Start with the manufacturing sector. Although it accounts for only about 11% of US GDP, it is generally regarded as a barometer of trends in employment and other indicators of the health of the broader economy. It is also politically significant, the sector that Trump the campaigner promised to restore to rude good health after debilitating attacks by foreigners using unfair trade practices.

The chief economist of the National Association of Manufacturers, Chad Moutray, expects factory output to grow at a rate of only 1.3% this year, a bit less than half of the 2018 rate. Chris Williamson, an economist with London-based IHS Markit, “a global information provider”, says the firm’s index shows that May was “the toughest month in nearly ten years” for US manufacturers. Bad news for a President who must carry Ohio and other manufacturing-heavy states if he is not to return to Trump Tower.

Housing is another sector that is unlikely to give the economy much of a boost in the near- and medium-term. Sales of existing homes in April were 4.4% lower than in the same month of 2018, the 14th straight month of year-over-year declines. New home sales, a much smaller part of the total housing market, also fell sharply, although remaining up from last year.

Although there are cheerier signs, among them better-than-expected auto sales and a high level of consumer confidence, an increasing number of economy-watchers are using the R word, “recession”. The NABE panel sees recession risks rising rapidly from 15% this year to 60% by the end of 2020. Both Goldman Sachs and Morgan Stanley report that their in-house indicators have turned negative, suggesting that the business cycle will soon move from what Morgan Stanley calls “an expansionary phase” to a “downturn.” Unless trade problems are eased, adds Chetan Ahya, the bank’s chief economist, “We could end up in a recession in three quarters”. That’s just about when voters will be preparing to trek to the polls to decide whether to turn the country over to Trump once again, or to whomever emerges with the nomination from the 24-person (current count) Democratic-nomination scrum.

Much will depend on the two key players, the President and Fed chairman Jay Powell. The President has an itchy twitter finger, and is already talking about placing tariffs on imports from India and the EU. Which puts pressure on Powell. After retreating from a threat to raise interest rates two, or perhaps three times this year, the Fed lapsed into a period of “patience”. That set share prices roaring, until they weren’t, and fell off the cliff which they had climbed. To the rescue: Powell announced that the Fed is “closely monitoring” the effect of tariffs, and “will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2% objective.” Share prices jumped over 2% after he spoke, and have continued rising, with some help from Xi Jinping who, speaking at an economic forum in St. Petersburg, declared that Trump is “my friend”, and that neither of these buddies is interested in ending the “strong trade and investment ties” that bind China and America. The response of a candid and thoughtful American president to his Chinese counterpart, a man intent on creating a trading system uncongenial to market economies, might well be, “Speak for yourself, Xi.”

The market now assigns a 72% probability to a rate cut at the Fed’s July meeting, and is expecting further interest rate reductions in September and January. They have reason: New York Fed President John Williams, last week said officials “need to be prepared to adjust our views to what’s happening in the economy…”. And what is happening is a strain on the trading system and rising uncertainty as to the volatile President’s intentions. Williams added, “We may need to keep interest rates the same, or we may need to adjust them.” Markets are betting on the latter, especially since inflation has persistently refused to hit the Fed’s 2% target, removing any fear that lower interest rates would trigger inflation.

There is an irony in this. Powell successfully defended the Fed’s independence when Trump began calling for lower rates. But Trump’s tariff policy now determines Powell’s monetary policy. An increase in tariff rates is the equivalent of a tax increase, a tightening of fiscal policy. If that creates a serious drag on the economy, the Fed chairman will almost certainly have to lower rates to offset that drag. In effect, the Fed has become Trump’s tariff enabler.

The President has discovered that his most potent weapon in dealing with other countries, and one that does not require congressional approval, is his ability to deny access to America’s enormous market. He “loves tariffs”. If that affection slows the economy, the Fed will have to ease rates, a new kind of bail-out, this of the President.

Fed watchers are eager to see how Powell would explain easing monetary policy in an economy with low, low unemployment, and rates already at zero when inflation is taken into account. Overtime work for the Fed fudge factory.