Next week the Fed will make a decision on whether to hike rates or keep them steady. Since the last time I wrote about this topic, the chance of a rate hike has fallen from 100% to 92.7%. The idea that the chance of a rate hike is 100% was over the top given the Fed has not explicitly guaranteed a hike. This lowering of chances has brought them to a more rational amount. I still expect a rate hike in December after we’ve seen some moderate pickups in data and heard some hawkish language from the Fed. Objectively, the economy has been stronger at other parts in this recovery, so when I say the Fed will raise rates in December, I’m not defending it as consistent, rational decision making.
The Fed now has to deal with President Trump’s economic policies when answering questions, making forward guidance, and making decisions on rates and the size of its balance sheet. Not surprisingly, the Fed has made mistakes in the recent statements it has made regarding Trump’s potential policies. I will go over them in this post.
The Fed has warned Trump against doing explicit stimulus because the economy is not in a recession and the employment picture is strong. I’m not a fan of stimulus either, but not for the same reasons as the Fed. Fiscal spending has a negative multiplier effect as the short-term growth created by spending is outweighed by the drag the debt increases have on the economy. Per Lacy Hunt, the government spending GDP multiplier is -0.01. It’s an obvious conclusion to make given the economy has taken on more debt over the past few decades, only to have slowing GDP growth per capita.
However, the Fed is not against Trump doing deficit spending because it hurts the economy. It thinks it helps the economy too much which will cause it to over-heat which will cause inflation to rise and the Fed to have to raise rates. While I agree with the Fed, that the economy is not currently in a recession, the idea that the economy is close to growing too fast is wrong. The annual GDP growth rate as of October is 1.6%. I also question the narrative that economic growth being too strong causes inflation. It depends on what kind of growth we have. If we have true economic growth caused by increases in production, then prices will fall. If we have growth in spending caused by the middle class taking on more debt, we will see inflation. Trump should try to spur economic growth because this recovery has been weak; he shouldn’t worry about growing the economy too fast. He should focus on creating an environment where we can have true capitalism, so real growth can occur.
Trump’s policies are a mixture of capitalist principles and more of the same bubble economics where the government spends money it doesn’t have. Unfortunately, the Fed will respond to either form of economic growth prospect by trying to slow the economy down by raising rates. It would be terrible for the shor- term economy if Trump created real economic growth through tax cuts and regulation cuts and the Fed responded by raising rates very fast. At the same time, the Fed does need to unwind its extreme policies, so Trump proposing good policies and having them drowned out by the popping of the bubble could shorten the lifespan and decrease the depths of the crash.
Another point the Fed is likely thinking, but not stating is if Trump goes the route of deficit spending, then it will have to finance the increased debt by monetizing the debt in a QE 4 program. Trump can’t overheat the economy, but he can blow up the debt to unsustainable levels. The Fed then contradicts itself by being opposed to a stimulus by stating getting rid of some regulations, fixing the tax code, and doing infrastructure spending would be good ideas. The tax cuts and the infrastructure spending are his plan for economic stimulus, so there’s no space for the Fed to agree with them, but be against explicit stimulus. They are the same thing.
The final point I will make is the Fed praises Trump’s simulative efforts because they would increase productivity. I disagree deficit spending on infrastructure would increase productivity. As you can see from the chart below, the decline in productivity has been a decades long trend. The Keynesians keep going back to the well of infrastructure spending, but it hasn’t worked.
Part of the reason the we’ve had poor productivity growth is because of monetary policy. When the Fed asks Trump to boost productivity, it is asking him to fix the problems they created. The low interest rates are causing companies to borrow money and buyback their own stock which they use for stock option bonuses. This doesn’t create productivity growth. What creates productivity growth is investment in the business. Another problem low interest rates cause is bad acquisitions. We are at the end of the business cycle and money is cheap. This encourages companies to borrow money to buy their smaller competitors to create manufactured growth. If an acquisition doesn’t have business sense, as many of these don’t, then productivity is hindered. The buyer ends up firing many of the employees and writing down the purchase as a loss.
The central banks are trying to eliminate recessions, by coming to the aide of the market every time we see a minor correction. Extending the recovery is phony because an increasing stock market doesn’t generate the real demand businesses need to justify investment. We need to have a real recession where the market reprices assets to fair value. Then when we have a real recovery based on free markets, there will be an increase in business investment.
The current bailout economy we live in creates zombie companies which never grow properly. The less free the economy becomes, the lower productivity growth will be. As you can partially see from chart below, the U.S. Index of Economic Freedom has declined 7 of the past 8 years to the lowest rating ever. Declines in labor freedom, business freedom, fiscal freedom, and the increasing regulatory burden have all led to the U.S. falling to 11th place on the index compared to the rest of the world. We need to reverse those trends to create productivity growth.
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