Its the Fed’s fault (too)!

Its the Fed’s fault (too)!

Almost from day one, the president has expressed his displeasure with Fed chair Jerome Powell for not dramatically decreasing the Fed funds rate. The president wanted two things. First to head off a slowing of the economy and second to reduce the cost of financing the ever increasing federal government debt. To recap, the Fed doesn’t control interest rates. The market does. What the Fed does is to affect short term rates that are tied to the Fed funds rate which is the rate on overnight borrowings of banks’ excess reserves. If the Fed wants to lower the Fed funds rate it must increase the supply of bank reserves. It does this by purchasing Treasury bills from the banks which increases bank reserves. Since banks lend out excess reserves (those reserves above what is required) and now are holding too many excess reserves, they increase their lending thereby leading to increased consumer spending and business investment.

Or that is what is supposed to happen. But not always. Didn’t we have near zero short term rates during the reign of George Bush the Second, Obama, the latter part of Trump’s first term and during Biden? Those were times of low economic growth. So why does the president think things will be different this time? Why don’t zero short term rates necessarily spur consumer spending and business investment? It is the old adage of being able to lead a horse to water. I remember my sainted mother asking why did the Fed hate old people when her CDs were earning virtually nothing. You can’t force consumers to start spending if their sentiment about the economy is in the dumps. You can’t spur business investment and hiring if there is little consumer demand and businesses are failing.

Today’s economy is showing signs of weakness in employment. Job growth is either anemic or nonexistent. Inflation keeps hovering above the Fed’s target of two percent at around three percent. The Fed, obviously more concerned about employment than inflation just lowered the Fed funds rate for the third time. Doing so has increased bank excess reserves. What the banks will do if they cannot lend out those excess reserves is just to hold them since the Fed actually pays the banks some interest on their reserves. The Fed can then turn to monetizing the national debt, namely buying Treasury bills that are being used to finance the debt directly from the Treasury or its agents. This is purely inflationary. The increased inflation or the threat of increased inflation leads to increased bond rates as long term investors seek to minimize losses of holding longer term securities. This will have the effect of increasing government borrowing costs since most of the government debt is in longer term Treasurys rather than in shorter term Treasury bills. Therefore the president’s demands can work against himself if lowering short term interest rates lead to an increase in inflationary expectations, an increase in longer term Treasurys and an increase in the cost of servicing the government debt.

I have often said that the Fed’s twin mandates of low inflation and full employment are often incompatible and the Fed must choose one or the other. There are Fed members more concerned about inflation than full employment and vice versa. The current votes of the open market committee reflect that division. I personally feel that for the overall long term health of the economy that inflation should be job one. But the pressures of Washington politicians on the Fed are generally in the other direction. But Trump’s push to a one percent Fedd funds rate is reckless at best. Some say that he really doesn’t want the rate to be that low but is using that tactic to get some lowering of the Fed funds rate. Well you could have fooled me.

All things considered, its the government’s fault. The higher rates are mostly because of the government itself with its ever higher spending and growing accumulated debt. The Fed is just a convenient scape goat for the consequences of government excesses. If Trump really wanted lower interest rates he should lead the charge of federal austerity. Fat chance. Instead we got the One Big Beautiful Bill which increased spending, deficits and government borrowing through more Treasury bills to finance it all. So in reality, it is not all the Fed’s fault (or Joe Biden’s). It is the president’s. He knows it but like all politicians seeks to shift the blame. 

Raise your hands if you thought that a republican president along with republican control of both the House and the Senate would lead to more fiscal responsibility rather than the same old stuff. Someone once said that in Washington, republicans are only democrat-lite. Increased spending and demanding lower interest rates seem to be universal among Washington politicians regardless of party (with the possible exceptions of Thomas Massie and Rand Paul). What happened to all those who were elected as fiscal hawks? With the federal debt to GDP constantly rising, it will be interesting to see what happens to the economy when the dollar’s status as the world’s reserve currency is truly threatened. There are none to take its place. What happens when the dollar loses so much value that like in many countries our citizens start moving away from the dollar into cryptocurrencies? What will the Fed do then? What can it do? Interesting questions all but most likely I won’t be around to ponder the answers.