The Congress Runs Up Deficits, The Fed Runs Down Rates

Recoveries don’t die of old age. They are murdered by policymakers. That was true in the 1930s, and it may well be true these many years later. Post mortems are likely to discover that the politicians and the Fed will turn out to be partners-in-crime, the politicians by drowning the recovery in red ink, the Fed by pouring the gasoline of lower interest rates over an economy that would have been better left to its own devices.

Start with the politicians, who found something on which they can agree. Just last week congressional Democrats, congressional Republicans and the President of the United States engaged in a love-fest, and agreed to suspend the ceiling on the national debt until after the 2020 elections and, they hope, their re-elections. That eliminates annoying limits on new spending, some $320 billion of it in the next two years above the limits set in the 2011 budget law. As Washington Post columnist George Will notes, “From the political class’s point of view, the beauty of enormous deficits, is that they make increments of mere hundreds of billions seem not worth bickering about.”

The Republicans get more money for the military, the Democrats for what Chuck Schumer and Nancy Pelosi prefer to call “robust funding for critical domestic priorities”. Future generations, already facing the burden of carrying the burden of trillion dollar deficits willed to them by their parents and grandparents, get an even larger debt pile and higher interest payments to make some day after revenge on the retired profligate pols is possible. Posterity is not well represented in the voting booth.

There are, of course, times when a massive loosening of fiscal policy might be defended as an appropriate means of forestalling a recession. But none such seems to be in our immediate future. Or when deficits might properly be incurred to finance long-lived investments in infrastructure that have pay-backs in excess of the interest cost on the debt. But with the exception of the cash to be invested in the nation’s security, the new borrowings are not by-and-large hardly headed towards long-term investment.

FDR aide Harry Hopkins is alleged to have promised to “spend and spend” but, his boss believing that a balanced budget would cure the Great Depression, only while he would also “tax and tax”. The current lot promise to spend and spend and spend while at the same time reducing taxes. Trump is claiming credit for acting as compromiser-in chief, ignoring his promise when faced with a similar bill in 2018, long ago as politicians count the age of promises, “I will never sign another bill like this again – I’m not going to do it again.” And that bill boosted spending by a mere $1.3 trillion.

No one should be surprised that House Democrats felt no compunction about spending more than the Treasury was taking in. It has always been their view that their constituents deserve benefits the nation can ill afford. House Republicans recovered a bit of the honor lost after the Trump takeover of their party by voting 132-to-65 against the deal, defying a vindictive President with a 90% approval rating from party members. This demonstration that the President has not completely expunged fiscal prudence from “his” party’s priorities could not overcome a massive Democratic Party majority in favor.

What should be surprising is the change in the Fed’s approach to monetary policy that will be announced in just a few days when the Bank’s monetary policy gurus gather to decide wither interest rates. After Alan Greenspan’s multiple terms as chairman of the Fed’s board of governors ended in 2006 after almost two decades, Ben Bernanke and Janet Yellen, both distinguished academics, occupied the monetary policy hot seat for a dozen years. It would be unfair to call their tenures merely conventional, since they took on the worst recession the nation has seen, and did so with considerable effectiveness, willing Powell a healthier economy than they had inherited. But that was then, this is now — the Age of Heightened Uncertainty, America’s refusal to play piñata to its trading partners’ palos, rapid changes in economies and markets, and increased doubts about the relationship of growth to other economic variables.

The current chairman, Jay Powell, already a Fed governor for six years when Trump elevated him to the chair at the suggestion of Treasury Secretary Steve Mnuchin (to the ex post ire of the President), is familiar with all the academic literature on monetary policy, but is no academic economist. He is a lawyer-turned-investor-turned-millionaire (The Carlyle Group). As such, he is more sensitive than his predecessor to signals from the markets, including those emanating from abroad, and is prepared to give them considerable weight. He also must be sensitive to the heightened uncertainty created by a President different in approach from his predecessors’ bosses, George W. Bush and “no drama Obama”, both more respectful of the traditional although at times strained relationship between a President and an independent Fed chairman.

The American economy, says Powell, is in a “good place.”

  • It grew at an annual rate of about 2.6% in the first half of this year, slower in the first quarter than in the second, but not bad at all;
  • unemployment has been at or near a record low, and the economy created 224,000 jobs in June (data for July will be available Friday);
  • wages are rising;
  • durable goods orders surprised by rising in June at the fastest rate since last August;
  • retail sales are rising at the fastest pace in five years according to Macroeconomic Advisers, having risen for four consecutive months, including a rise in June of 13.4% over last year’s figure;
  • consumer spending rose at a 4.3% rate in the first quarter. Consumers seem to be ready, willing and able to spend on everything from restaurants to apparel, although they are a bit more reluctant than in the past to clear the lots of every vehicle car makers ship to dealers.

There’s more, but you get the idea: there is little in the economy’s current performance to suggest the need for lower interest rates. Yet just such an easing is what we will see in a few days. That is because Powell is not focusing primarily on the rear-view mirror, but on the ruts in the road ahead.

For one thing, the trade war with China, an almost certain imposition of tariffs on French goods to offset Macron’s taxes on America’s digital companies — there are no successful large digital companies in euroland, — and the possibility of a trade war with the EU should Trump’s tweeting finger get itchy, is causing corporate America to re-examine its investment plans, and not with a view towards ramping them up. For another, other economies are not performing as well as America’s.

In the second quarter China’s economy grew at its slowest rate in almost thirty years, despite tax cuts and an easing of already-wide-open credit taps. And there are signs that the masters of the state-run economic model cannot manage its huge economy now that use of its favorite tools – IP theft, barriers to entry of foreign firms, massive subsidies – might be denied it by a long-delayed American reaction to their effects. Especially since his policy towards China has bipartisan support from virtually all save those of his critics suffering from TDS (Trump Derangement Syndrome). Julian Evans-Pritchard, China economist at Capital Economics, says “We see more weakness on the horizon” for China’s economy.

The eurozone is also displaying significant weakness. Manufacturing activity is at a 79-month low, overall growth and job creation are falling, and the EU’s largest economy, Germany is experiencing “an accelerated drop in export orders – the most marked seen in over a decade,” according to Phil Smith, economist at IHS. Italy’s economy is dormant. Greece’s is still staggering under the weight of German-imposed “reforms”. Britain might, only might, be preparing for a Brexit that would add to the eurozone’s problems. Outgoing head of the European Central Bank, Mario Draghi, sees “weakness” ahead, with “the balance of risk on the downside.” And has set the stage for a round of stimulus either as he exits the stage or for Christine Lagarde as she takes her place at the Bank’s stage-center, a move that will face Powell & Co. with Trump’s demands that he weaken the dollar in response.

Whether a few signs of slowing in the US, trade uncertainty, pronounced weakening in China and the EU are reasons enough for the rate cut we will see in a few days – the first in more than ten years — depends on whether Powell wins his three gambles. The first is that even with deficits soaring, he can contain inflation at or a bit above the Fed’s 2% target. Appraising the odds of a win is made somewhat difficult by the fact that the Fed’s preferred measure of inflation is either 2.3% or, ex-volatile elements (food and energy) 1.8%, the former being above its 2% target, the latter below it.

The second gamble is that the interest rate reductions will not exhaust the ammunition Powell will need should the economy be hit by the depression some are anticipating for next year, unless the Fed is to turn to negative real interest rates, a tool tarnished by experience.

The third is that, given the uncertainties surrounding trade policy, it is better to risk reducing rates too much too soon rather than by too little too late.

Meanwhile, we are living in a brave new world in which the preferred policy for a growing economy that is running a large deficit and has historically low interest rates is to increase the already large-and-rising deficit and to lower already-low interest rates. Makes sense to the occupant of 1600 Pennsylvania Avenue, who might add to that mix an attempt to drive down the value of the dollar, as Washington rumors – denied – have it.