Fed running out of monetary ammunition
Trump's pursuit of ultra-easy policy could overheat US economy
by Desmond Lachman in Washington
Thu 18 Apr 2019
It is clear that President Donald Trump's administration is not concerned with whether the US will have enough ammunition left to fight the next economic recession. Had it looked into this basic question, it would not now be leaning so hard on the Federal Reserve to cut interest rates and to engage in yet another round of quantitative easing at a time when the US least needs a monetary policy boost.
The unemployment rate is the lowest in decades and interest rates are at historically low levels. Equally, over the past decade the Fed's balance sheet has bloated to $4tn, distorting asset and credit market prices in the process. Yet Trump keeps pressuring Fed Chair Jerome Powell to cut interest rates and to engage in more QE.
In an effort to get his way, Trump has nominated economic commentator Stephen Moore and Herman Cain, a former presidential candidate and pizza magnate, to fill vacancies on the Fed's board of governors. Both lack the minimum monetary policy expertise required for the roles. Rather, they are known as being people on whom Trump can rely to do his bidding.
The president's quest for an ultra-easy monetary policy at this late stage in the economic cycle might cause the US economy to overheat and thereby rekindle inflation. Moreover, it would leave the Fed with scant ammunition to fight the next recession.
With the Fed funds rate already as low as 2.25%-2.5%, further cuts would leave the central bank with limited room to slash interest rates in the event of a slowdown. Similarly, it would be difficult for the Fed to expand the size of its balance sheet to support a struggling economy, and credit spreads are already highly compressed.
The lack of room for future monetary policy manoeuvre would not be so serious if the US had sound public finances. However, here too Trump has acted recklessly. In 2016 he enacted a massive unfunded tax cut that, according to the Congressional Budget Office, will add $1.5tn to the US debt over the next decade.
The consequence of Trump's fiscal largesse is that, even in the best of circumstances, the budget deficit will be stuck at around 5% of GDP. In the event of a recession, the deficit would balloon further as the US tax base would decline. This would leave the government with little space to use fiscal policy to support the US if the global economy was to experience another recession.
Hopefully the president will back off from pressuring the Fed for an easier monetary policy stance. This is especially the case as the threat of a global economic slowdown, coupled with an aggressive 'America first' trade policy, could push the US economy into recession. But, based on Trump's past disregard for history's many lessons about the long-run economic costs of irresponsible macroeconomic policies, as well as his need to find a scapegoat should the US economy take a turn for the worse, we should not expect him to ease up on his Fed bashing anytime soon.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.
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