Robert J. Samuelson: The odd couple: Trump and Powell

If ever there was a case of political miscalculation, it’s the collapsing relationship between President Trump and the chairman of the Federal Reserve Board, Jerome (“Jay”) Powell.

Trump seems to have believed that he could easily manipulate Powell into embracing an aggressively easy monetary policy whose main objective was Trump’s re-election. For his part, Powell seems to have believed that, although Trump would periodically challenge the Fed’s behavior, he would fundamentally respect its “independence.”

Wrong on all counts.

Instead, we’ve gotten a schoolyard brawl. After the Fed’s decision last week to cut its key lending rate (the Fed funds rate on overnight loans among banks) by a quarter of a percentage point (to a range of 1.75%-2%), apparently not enough for Trump, the president unleashed one of his furious tirades. “Jay Powell and the Federal Reserve Fail Again,” Trump tweeted. “No ‘guts,’ no sense, no vision.”

Previously, Trump had called Powell a “bonehead” and an “enemy” of the country, comparing him to Chinese President Xi Jinping. Just about the only thing Trump hasn’t done is insult Powell’s mother. But who knows what happens next?

All this makes good copy and, perversely, contributes to widespread uncertainty that weakens the economy. There is no mystery about Trump’s game. He is setting up Powell and the Fed as scapegoats should the economy slow sharply or fall into a recession.

Yet, beyond these political theatrics, there is a more complicated story that is largely being missed. The Fed may be approaching – or may have already reached – the limits of its economic powers. Over recent decades, we (meaning politicians, public officials, institutional investors, pundits and economists) have assumed that the Fed had enormous powers to direct and shape the economy.

Paradoxically, the Fed’s reputation benefited from its role in preventing the 2008-09 financial crisis from turning into a second Great Depression. The Fed flooded the economy with cash. This rescued some large financial institutions. even though the Fed was also complicit in the complacency that caused the crisis in the first place.

Recall the basic model by which the Fed supposedly manages the economy. It raises or lowers the interest rate on fed funds, which are overnight loans largely among banks. If the economy is lackluster, it lowers rates to stimulate borrowing and spending. The decline in the fed funds rate causes rates to fall on home mortgages, corporate bonds, consumer loans and other forms of credit that affect the economy. Similarly, if inflation is too high, the Fed raises rates to slow the economy and dampen price increases.

This, of course, is a highly simplified version of what happens or, at least, what’s supposed to happen. But what if these assumptions are only partially true or, at times, not true at all?

Then the Fed’s influence on the economy is overstated. So concludes a new study by economists Alan M. Taylor of the University of California, Davis, and Oscar Jorda of the Federal Reserve Bank of San Francisco. They examined interest rates from 1955 to 2018 for four major countries: the United States, Japan, Germany and the United Kingdom. They found that “interest rate setting is driven by factors outside policymakers’ control.”

The economists add: “In this paper we show that global forces set the course of interest rates over the medium to long run. This happens to a degree perhaps insufficiently appreciated.” The Fed is important, but it’s not omnipotent.

The economists attribute about 40% of interest rate changes to deliberate policy decisions by central banks and most of the remaining 60% to various long-term factors. The understanding of interest rates and credit conditions requires a global viewpoint and not, as is often assumed, mainly a domestic one, the economists argue.

Although they don’t say much about what those factors might be (more research!), plausible candidates include: inflation, both high and low; demographic shifts – younger or older populations; changes in savings and investment behavior; technological changes; the rise of China and other “emerging market” countries; large-scale global capital flows – mass movement of money among countries.

The Trump-Powell feud shows no signs of abating. Trump may even call for an overhaul of the Fed to centralize more power in his hands. This would be undesirable, but even if he succeeds, Trump might discover that some of the powers he so covets have already moved offshore.