Doves on the Federal Reserve evidently have a vocal ally in President Donald Trump. He said recently he’s “not thrilled” about the Fed increasing interest rates – a move the central bank was expected to signal recently.
The president’s concern comes while interest rate watchers are getting nervous about how rapidly the yield curve is flattening, with the rates on 2-year and 10-year notes continuing to converge. While it seems likely for now the Fed will continue to increase interest rates at least until they returned to the Fed’s estimation of “neutral” or the yield curve inverts, a pause at that level has the potential to signify the Fed has finally gotten past the era of high interest rates, a precedent set in the 1970s.
Pausing, perhaps ending, interest rate hikes over the next several months would represent a sea change not just for monetary policy, but also for the makeup of the U.S. economy as it’s been since the early 1980s. Following the trauma of high inflation in the late 1970s, the Federal Reserve … has been obsessed with maintaining the credibility of the U.S. central bank as an inflation fighter. The Fed has shown it’s been successful at holding inflation at bay, but that has come at a cost.
One of the main ways the Fed has won its credibility on inflation has been setting interest rates higher, sometimes much higher, than the inflation rate. When investors and savers can get a “free lunch” by earning a high inflation-adjusted return in Treasuries, they’re incentivized to do so rather than invest in new production or consuming goods and services, both of which would put upward pressure on inflation.
But this has broader distortionary effects in the economy. On a global level, if investors can earn a high real interest rate on U.S. assets, they’re going to do so, which all else equal will drive the dollar higher in foreign exchange markets than it otherwise would be. The dollar being artificially higher will make U.S. exports less competitive in global markets, leading to larger trade deficits.
In other words, the Fed established its credibility on inflation over the past few decades by setting real interest rates at a high level, which helped to orient the economy around financial activities, consumption and imports rather than production, labor and exports. This economy had winners and losers, of course: American consumers benefited, at the expense of many workers in the manufacturing sector.
Trump wants a different model. It’s what his tariff threats seek to accomplish: making the U.S. economy more production-oriented rather than consumption-oriented. And he wants monetary policy to help do the same thing. If the Fed stops increasing interest rates over the next few quarters, then we’ll never get those high real interest rates in this economic cycle that we’ve gotten in past cycles. This should put downward pressure on the dollar, making U.S. exports more competitive, but at the cost of cheaper imports for U.S. consumers.
In the long run, if trade and monetary policy leads the U.S. economy to be somewhat less consumption-oriented and more investment-oriented, that’s something we can handle. But that global adjustment won’t be easy. Countries and businesses have allocated resources and made investment decisions based on certain assumptions about trade arrangements and currency relationships. You can’t move automobile and semiconductor production overnight; even moving them slowly will incur high switching costs.
It’s not just recession fears or the threat of an inverted yield curve that should most worry investors, but rather all the various pain along the way if the global economy is forced to rebalance.
Conor Sen is a Bloomberg Opinion columnist.
