We’ve written voluminously about the moral hazard inherent in the Fed allowing itself to be co-opted in Donald Trump’s increasingly quixotic trade war.
Life is becoming wholly miserable for the central bank. Jerome Powell took a big risk this year by placating the president, who now knows he can commandeer monetary policy simply by engineering outcomes in short-end rates markets.
By acting increasingly unhinged on trade, Trump can force markets to price in Fed cuts, and when that pricing becomes extreme enough, it puts the Fed in a position where policymakers have to choose between disappointing markets at the risk of tightening financial conditions, or effectively doing the president’s bidding. Here’s how the pernicious feedback loop works:
Trump is playing the Fed directly (via shrill tweets and explicit exhortations for rate cuts) and indirectly (via the rates market, as described above). He did it on August 1, escalating the trade tensions when Jerome Powell’s post-FOMC press conference didn’t go the way the White House wanted it to go, and he did it again on Friday, throwing a fit on social media on the apparent assumption that Powell should have said something more explicit about the Fed’s intentions in Jackson Hole.
Analyst after analyst has warned that this is a dangerous game.
“For one, [the Fed] will probably be trying to offset an even larger negative economic shock but even if that shock does not materialize, the rally in rates means that the Fed will have to use up more ammunition if it wants to meet market expectations and avoid financial tightening”, BofA wrote last month, adding that “the risk is of a perverse feedback loop in which trade-war escalation keeps offsetting Fed easing, leaving the Fed with very little ammunition to fight the next recession, while the economy remains relatively soft”.
Well, on Tuesday, Bill Dudley weighed in via a Bloomberg opinion piece which carries the headline “The Fed Shouldn’t Enable Donald Trump” and a sub-header which reads “The central bank should refuse to play along with an economic disaster in the making”.
That’s really all you need to read to understand Dudley’s point, but the nuance is important.
Dudley writes that under normal circumstances, the Fed would simply respond to what’s going on without concerning itself with what “message” it might send. “The Fed, for example, wouldn’t hold back on interest-rate cuts to compel Congress to provide fiscal stimulus instead”, he notes.
But this time is different. And here’s why (from Dudley):
So, according to conventional wisdom, if Trump’s trade war with China hurts the U.S. economic outlook, the Fed should respond by adjusting monetary policy accordingly — in this case by cutting interest rates. But what if the Fed’s accommodation encourages the president to escalate the trade war further, increasing the risk of a recession? The central bank’s efforts to cushion the blow might not be merely ineffectual. They might actually make things worse.
That is essentially a reiteration of something Deutsche Bank’s Aleksandar Kocic outlined in June.
“When discussing the risk/reward of preemptive cuts versus restraint, the comparison should be made between the Fed doing nothing and risking that political negotiation process triggers a recession, or that the Fed could get dragged into becoming a permanent part of the policy mix with all the implications that role entails”, Kocic wrote, in the course of warning that “the current possibility of crossing the political event horizon is associated with a potential loss of Fed independence, a sign of contamination with political entropy and, as such, a loss of informational content and transparency”.
For his part, Dudley proposes a solution – namely that the Fed should publicly and emphatically tell Trump to pound sand (he doesn’t put it in those terms, but it’s close).
“Officials could state explicitly that the central bank won’t bail out an administration that keeps making bad choices on trade policy, making it abundantly clear that Trump will own the consequences of his actions”, Dudley says.
And he goes further still, to wit:
Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks — including the risk of losing the next election.
Suffice to say Donald Trump isn’t a man that would take kindly to such a rebuke. In addition to being an affront, it would rob the president of a scapegoat. And by many accounts, he’s going to need all the scapegoats he can get by the time it’s all said and done.