Deciphering the Fed's reaction to Trump

Opinion Saturday 19/November/2016 15:05 PM
By: Times News Service
Deciphering the Fed's reaction to Trump

Nobody is really sure what Donald Trump will want from the Federal Reserve during his presidency: Will he try to make it adopt the “hard money” views of many people in his party, or will he want it to err on the side of letting the economy run hot?
Since we might not know the answer for some time, the monetary-policy discussion has turned to the question of how the Fed should react to Trump.
A recent headline predicts that “The Next Great Debate at the Fed Will Be All About the ‘Monetary Offset.’” Trump plans to cut taxes and raise spending on infrastructure, stimulating the economy. The Fed can counteract the stimulative effect of these policies, however, if it raises interest rates faster or more than it would have in their absence.
Two things about monetary offset are easy to miss, at least if my experience in arguing about it is anything to go by.
The first is that the question, “Will the Fed offset Trump’s policies?” is really just another way of asking, “Will the Fed stick to its existing objectives?”
The Fed appears over the last few years to have been trying to keep its preferred measure of inflation running at 1.5 to 2 per cent a year. If this is its objective, it will raise interest rates when inflation threatens to rise above that level -- whether the cause of that rise is Trump’s policies, upward movement in energy prices, an increase in home sales, or something else altogether. The Fed, that is, need not have any intent to subvert Trump: Just continuing its existing inflation target will have the effect of doing so.
Claims that higher deficit spending will stimulate the economy, or that lower deficits will contract it, typically ignore the monetary-policy reaction. To the extent that the Fed is targeting inflation and doing so effectively, however, neither effect will happen.
The second point that’s easy to miss is that even if the Fed does counteract fiscal stimulus, it doesn’t mean that the components of the fiscal stimulus are a mistake. If Trump’s tax reforms increase incentives to work, save and invest, or reduce distortionary tax breaks, that effect will survive higher interest rates. If infrastructure spending improves American productivity, it’s worth doing on those grounds rather than because it puts money in workers’ pockets.
Those are big ifs. But if we pursue these policies, we should do it for those reasons, and not because they will help the economy by increasing the deficit. This will happen only if the Fed decides to abandon its 2 per cent ceiling on inflation -- and if it wants to do that, it does not need Trump’s budget plans to proceed. - Bloomberg View