Introduction to the Federal Reserve and Interest Rates
The current debate between the Federal Reserve and the president appears to be about whether to keep the current interest rate to reduce demand, free up supply, and keep inflation in check. However, this is not just a simple argument about interest rates. Like a cancer treatment, high interest rates can make the economy sick, but they can also prevent inflation from getting out of control.
The Role of the Federal Open Market Committee
The Federal Open Market Committee (FOMC) is responsible for setting interest rates, but is it truly independent? The answer is no. The FOMC’s independence cannot be maintained if it stands against policy. If the FOMC is for one policy and against another, then it is a de facto partisan actor in that policy fight.
Can the Fed Affect Tariff Inflation through Monetary Policy?
The Fed has labeled potential inflation resulting from tariffs as something that requires monetary policy to address, but can it really affect tariff inflation through interest rates? The answer is no. Businesses will adjust to higher costs or move supply chains to rebalance the cost of materials. Consumers will shift demand to account for the higher prices. Nothing in the Fed’s tools can affect that process.
The Impact of Tariffs on Inflation
Tariffs always cause inflation, but is it likely that other policy decisions can offset the costs of tariffs? Let’s review the FOMC’s tariff monetary policy from two vantage points. In the first case, if tariffs are offset by other cost factors like energy or AI, then they will not register as topline inflation and the Fed does not need to try to offset them with higher rates. In the second case, if tariffs are a transitory, one-time cost of doing business, then they are also not something the Fed should try to offset with higher rates.
Can the Federal Open Market Committee’s Models Accommodate the Growth Agenda?
Since President Trump’s trade negotiations require trillions in new investment, production, and new projects in the US, the FOMC policy must be recalibrated to accommodate a 4 to 5% annual growth in the US economy for the next several years. However, the FOMC models appear to be calibrated to 1% to 1.5% growth. Can the models be changed, and who would lead them to do that?
What’s Really Going On Between Powell and Trump?
Underlying the Trump/Powell clash is a deeper debate about Federal Reserve Rate orthodoxy. Specifically, are increases in the fed rate in and of themselves inflationary or deflationary? Orthodoxy says that the economy requires high rates to force a reduction in inflation. However, if the Fed reduces rates now, while inflation is above 2%, and inflation decreases, it will call into question decades of scripture about the tightening and loosening of monetary policy by the Fed.
The Conundrum
The concern is that if the Federal Open Market Committee did lower rates and inflation came down, it would destroy the guiding principles of the Fed that they have doggedly followed for 50 years. At stake in the current fed decision is something much more essential than the argument between Powell and Trump, even more important than the independence of the Fed.
Conclusion
In conclusion, the debate between the Federal Reserve and the president is not just about interest rates, but about the underlying principles of monetary policy. The Fed’s resistance to lowering interest rates is not just about inflation, but about preserving the orthodoxy of monetary policy. However, if the Fed is willing to reconsider its models and accommodate the growth agenda, it could lead to a new era of economic growth and prosperity. Ultimately, the decision is not just about the Fed or the president, but about the future of the US economy.
