- KPB & Co Research
Today Jerome Powell announced that the US Federal Reserves Open Market Committee cut the target rate for the federal funds rate by 25 basis points to the range 2% to 2.25%. Though the cut to the target had been telegraphed by committee members early on, the economic backdrop together with developments on the fiscal side and current Fed communications make one wonder whether the Fed is indirectly under the influence of the Central Government. Officially, the president of the United States of America does not have a direct bearing on the decisions of the Federal Reserves, but in situations where the Fed's mandate (full employment and stable inflation) is threatened by fiscal policy how much independence do they really have?
JEROME POWELL PRESS CONFERENCE - JULY 31, 2019
In discussing the rationale for the rate cut, the Chairman kept pointing to the impact that the ongoing trade negotiation with China is having on business investment, confidence, and growth in the manufacturing sector.
The outlook for the U.S. economy remains favorable and this action is designed to support that outlook. It is intended to insure against downside risks from weak global growth and trade policy uncertainty; to help offset the effects these factors are currently having on the economy; and to promote a faster return of inflation to our symmetric 2 percent objective
In the view of Fed officials, lower rates are needed as an insurance policy to protect against a slowdown in economic activity. It is very clear, that the tenuous relationship between the US and China is due to the particular approach of the president. When trade negotiations are going well, economic conditions seem energetic and when trade negotiations sour, economic optimism dampen.
A phenomenon that has become a growing area of angst for financial market participants is the growing level of government debt. The Trump administration has overseen a rapid rise in debt, as the fiscal deficit widened following the implementation of the US tax reform. Estimates from the Joint Committee on Taxation (JCT) and Congressional Budget Office's (CBO) show that the tax law would reduce revenues by US$1.65Tn from 2018 to 2027. The increase in the deficit is expected to be partly offset by US$194Bn in reduced spending mainly on health insurance. This combustible situation is further complicated by the massive debt burden that corporations are shouldering. The heavy debt load makes it difficult for the US Fed to increase rates without facing severe economic contraction. To some extent, we have seen evidence of this fragility in the last half of 2018 when the Q3 and Q4 ISM manufacturing index slipped, and the stock market plummeted as the Fed hiked rates. In both cases, an increase in interest rates would lead to a rapid rise in debt service cost, which in turn reduces the wiggle room the central government has to implement policy, and the room corporations have to make business investments.
Many investors also ponder whether the public pressure Trump puts on the Chair of the federal reserves is having an impact on the direction of monetary policy. Fortunately, the direction of monetary policy is determined by a vote of the federal reserves open market committee, and the voting process is open for the public to see. This makes it difficult for the central government to influence monetary policy through one person. On the other hand, the criticisms that Trump has placed on the Fed was done publicly, which may create a sense of uneasiness among committee members. What is clear, is that the president is not getting what he wants exactly:
Jay Powell did mention that another reason for the cut to target rates is the fact that inflation still sits below the target rate of 2% in spite of stellar unemployment numbers and GDP growth rates. So there is a motivation outside of the impact of fiscal policy. However, it clear today that the largest influence on monetary policy is fiscal policy albeit it is more indirect than direct. The policy direction of the US Fed has to account for the high level of indebtedness among corporations and the government, and the uncertainty caused trade tensions.