Is Donald Trump right in his assessment of Jerome Powell?

Featured image is in the public domain. Author: Federalreserve

As with so many of these “is Donald Trump right” type questions, you probably already know my answer! However, there is a great deal of nuance to the question at hand that concerns the impact of Jerome Powell’s projected 3 interest rate rises next year. Already in 2018 the Federal Reserve has raised the federal funds rate three times, and the financial markets expect another hike in December, making it a grand total of 7 rate rises in 2018-2019. Donald Trump has gone on record saying that he was “not even a little bit happy” with the selection of Powell as the Chairman of the Fed, primarily due to the number and pace of interest rate rises that are projected to occur under his watch. However, with interest rates still very low (the federal funds rate sits currently at 2.25%) relative to their post-financial crisis levels, one question remains: Is Donald Trump’s annoyance simply due to his spending-driven boom being stymied by Powell?

Looking at the argument from Trump’s perspective, you could make the argument that such quick rate rises are highly risky. This is due to the formation of asset price bubbles that have grown in size ever since the dramatic cuts in interest rates that happened during the financial crisis. Reportedly the US stock market is the most overvalued on record – more so than in 1929, 2000 or 2007. The metrics used for this are indicators such as price to earnings ratios, which are almost at the highest levels seen since 1870. Moreso, the “Buffett indicator”, or the total market capitalisation of the US stock market divided by US GDP, lies at 138%. This compares to a peak of 105.2% during the financial crisis and 136.9% during the dotcom bubble.

Low interest rates boost prices of asset such as stocks because they decrease the risk-free rate of return, leading to a greater incentive to invest in these riskier assets. Hence the prices of these assets (at least in theory) should rise in response to falling interest rates. The issue comes when rates rise again. If Powell is too quick in his rate rises the risk-free rate of return rises too quickly which potentially siphons funds away from stocks. Now, if stock prices drop too quickly then we see a rapid decline in the wealth of millions of Americans holding their funds, in some way or the other, in the stock market. As theory and practice have shown the likely outcome of this is then a rapid decrease in consumer spending, which leads to a decrease in business investment (through a decrease in retained earnings) and eventual recession. If this is what Trump is getting at, though, the question remains: how quick is too quick for Powell?

Taking a directly contrasting perspective, Powell also has a strong case for raising interest rates. Logically, the longer the period of time for which the risk-free rate of return is so low, the greater the asset price bubbles become in size. This indicates rapidly rising property and stock prices and thus high levels of inflation. With interest rates being one of the main tools the Federal Reserve has at its disposal to combat inflation, the most rational choice seems to be to stem the asset price bubbles before they get any bigger. If the bubbles pop, so be it: the alternative is to push the popping of these bubbles further down the line and eventually increase the severity of a recession. As mentioned before, given that we are already so far down the cycle, it makes sense economically to raise interest rates and cut the damage from a recession that may already be in the pipeline.

To summarise both arguments, the truth is that no one knows precisely how quick the Fed can raise rates before triggering a recession. However the heart of the matter lies in the rift between raising interest rates now or raising interest rates later. While true that raising rates now makes it far likelier for another recession to occur in the near term, the asset price bubbles that have built up across the US economy in asset classes such as stocks and property near guarantee another recession sooner or later. Trump’s dispute (in my opinion) exists because of his political self-interest; of course raising rates while he is in power dampens any economic boom currently existing, and thus his popularity. Economically, however, it remains the case that for me Powell is justified both in the existing rate rises he has carried out and also his forward guidance for the future. The decisions show prudence and responsibility, and whatever Mr Trump may think, I feel that this is what is best for the USA at this time.