Three Risks When Political Leaders Influence Monetary Policy

October 17, 2018

President Trump’s progressively blunt criticism of the Federal Reserve for a string of gradual interest rate hikes should surprise nobody. The president’s style of overturning institutions¬† has taken him very far in politics. Criticizing Fed policy, even though the Chairman and two of the other current governors are his appointees, fits a pattern that has been used effectively against the free press, the U.S. intelligence agencies, cabinet members, other top appointees, members of congress, judges, and leaders of countries that had been close allies of the United States.

A tradition learned from the school of hard knocks exists that presidents openly criticize monetary policy at their own peril — even in circumstances where they are worried that excessive tightening threatens U.S. growth or when, unlike now, the advice to Fed officials is dispensed privately as Nixon did to help get himself reelected in 1972.

Pressuring the Fed not to step on the monetary brakes carries several negative risks. Higher inflation is one possible result. Trump generally admires autocratic governments and is trying to tilt the United States further in that direction. A review of inflation in a who’s who of autocratic regimes underlines this danger. Venezuelan inflation last month hit 488865 percent. Inflation in Turkey and Iran is running at 24.5% and 24.2%. In Egypt, it’s 16.0%. Polish and Pakistani inflation are at 5.0% and 5.1%. Russia is reporting 3.4%. The most recent inflation quote from North Korea, dating back to mid-2013, was 55%, while that for Syria as of May 2017 was 27.1%, down from 50.4% in September 2016. In Great Britain, which didn’t relinquish elected government control over Bank of England interest rate policy until 1997, inflation exceeded 26% in the middle of 1975, some three times faster than in the United States at that time, and again was hovering around 10% in 1990. Before joining the euro area and adopting the euro, Italy experienced 20+% inflation at times in the 1970s.

Money matters. Prolonged expansion the money stock at a faster pace than money demand growth risks eroding expected inflation and the confidence of investors in the Federal Reserve’s commitment to preserving the internal and external value of the dollar. Significant dollar depreciation in the 1970’s and accelerating inflation created a vicious circle of reinforcing market dynamics. Only by addressing both dynamics simultaneously through prolonged quantitative tightening was either force contained, but restored price stability came at the cost of the severe double-dip recession of 1980-82. Even after, it took several decades before the mission of sustained low inflation won. Inflation exceeded 6.0% for a while in 1990 and was above 5.0% for a while in 2008.

A separate but related risk when governments pressure their central banks to create cheap money is that in spite of suppressed short-term rates, long-term interest rates climb to compensate investors for the possibilities of higher inflation and currency depreciation. When the Fed started a tightening cycle in early 1994, confidence in continuing low and stable U.S. inflation was still shaky, and the 10-year Treasury yield shot up from 5.6% at end January to 7.0% by mid-June and 8.0% in early November.

In 1995, U.S. Treasury Secretary Robert Rubin articulated a strong dollar policy that identified many benefits including low and stable import prices and overall inflation, lower long-term interest rates, and international confidence in the dollar as a lynchpin of the international monetary system.

Losing the dollar’s role as the world’s dominant reserve currency is arguably the greatest danger of President Trump’s aggressively public effort to use the bully pulpit of his office to influence Fed policy on interest rates. The need for dollar hegemony in world finance and trade is all the more vital with U.S. federal deficit widening by a sharp 17% to to $779 billion last fiscal year and presumably much higher in fiscal 2019. Weakened Fed independence in conjunction with perceptions of¬† U.S. domestic political instability and an insular foreign policy would strip away more of the preconditions underpinning dollar supremacy. Fortunately, no other currency is currently waiting in the wings to take over that mantel. Nonetheless, if the dollar squanders its power as sterling did earlier, it will be unlikely to ever recapture the immense benefits that flow from that status.

Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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