The Fed's Monetary Policy Is Becoming Unsuitable, Even President Trump Realized It

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by: Gio Danisi
Summary

The Fed’s policy of rising interest rates is not shared by other main central banks worldwide.

The Fed’s intent is not clear: the US core inflation is not worrisome and the unemployment rate is lower than it may look at first sight.

The results achieved by the Feds in the last 3 years are not thrilling: A flattening yield curve and a general uncertainty about the current stage of the US cycle.

Moreover, the Fed’s policy works against the Trump’s administration goal of reducing the US trade unbalance, as it intrinsically boosts the US dollar.

Further developments are not easy to forecast, but a change in the monetary policy is likely to happen during the medium term.

Nearly 10 years have passed since Ben Bernanke, former chairman of the Federal Reserve, launched the first Quantitative Easing to help US banks get rid of hundreds of billions in bad loans that were inexorably sinking them.

This move was equivalent to a classical "All-In" (speaking in poker terms) and was met with both criticism and support at the same time.

In hindsight, we can now say that Mr. Bernanke was right. His monetary policy helped solve the worst financial crisis US had faced since the Great Recession and put the first world economy back on the path of stability and growth.

However, over time, more and more voices were raised to warn that an overly accommodative monetary policy could trigger excesses similar to those that had produced the 2008 crisis.

Moreover, the party of the so-called rentiers, irritated by the fact that their safe T-bonds produce increasingly lower returns, has always been very influential in the United States.

Then, Bernanke's successor, Janet Yellen, gradually reduced Fed security purchase programs during her term, to the point of introducing a first wave of increase in interest rates.

With the 2016 White House (and US congress) political change, those in favor of T-bonds with higher yields were pleased with an American Central Bank board much more oriented towards a monetary tightening.

The new Fed Chairman, Jerome Powell, raised the target range for the Federal funds rate up to 2% and set the path for other two hikes before the end of the year. When Mr. Powell assumed office as Chairman of the Federal Reserve Board last February, the Federal funds rate was 1.5%.

Why the Fed should stop its tightening policy

The Fed's mandate has two well-known goals: Price stability and maximum level of employment. Is US inflation accelerating above guard level? Not exactly.

Source: Trading Economics

As we can see, during the last 5 years, the US core inflation has ranged between 1.6% and 2.3%. The last survey was carried out around the time inflation was at its highest point, as it had been for 3 times between 2016 and 2017, before falling back to 1.7 points. Therefore, it is too early to talk about a dramatic price hike.

More importantly, the 10-year T-bond yield today is around 3%, a sign that they are not expecting inflation to rise in the long run.

Three years of increases (seven consecutive ones so far), which brought the benchmark rate from 0% to 2%, have produced an increase of about 50 basis points to the 10-year T-bond yield and of only 20 basis points to the 30-year T-bond yield.

Basically, so far, the Fed's policy has caused nothing but a flattening of the US interest rate curve.

Source: U.S. Department of the Treasury - Author's elaboration

Perhaps the Federal Reserve knows something that financial operators do not know at the moment, because, in the long run, nobody expects US inflation to go much higher than the current level.

In any case, a general market uncertainty and anxiety were evident during the course of last year.

The American index (NYSEARCA:SPY) has gained about 4% since the beginning of the year, but has undergone sudden and deep retracements at least 3 times, the most dramatic above 5%. Now it is below the highest levels reached at the end of January.

Source: Yahoo Finance

This is nothing exceptional in a long-term perspective, but certainly enough to give voice to those who have been thinking for years that the current bull market has lasted too long.

As far as the level of unemployment is concerned, just to be clear, there are several indicators that measure the degree of unemployment.

Source: US Bureau of Labor Statistics

As we can see, both the official unemployment rate U-3 and all the other benchmarks are at their minimum levels in the last 20 years at least. However, the labor force participation rate is still below 2008 levels.

Source: Trading Economics

Therefore, the picture is not completely clear. Surely, there is not enough evidence that we are experiencing a total absence of unemployment in the US.

However, the Fed's monetary policy, different from other central banks' policies, has led to the following situation when it comes to international government bonds yields:

Source: Author's elaboration

All this is happening in the midst of growing international tension and a somewhat outspoken trade war.

Fed policy and Trump administration are on a collision course

No administration is happy to see its central bank become less and less accommodating during its mandate. After all, there will be less room for deficit spending if the cost of public debt goes up.

However, the situation is certainly more complex. One of Donald Trump's strong points has been the narrowing of the US trade deficit since his presidential campaign.

The simple idea behind it is that if fewer foreign goods enter the United States, the same products will have to be manufactured in the US, which would boost the country's job creation.

There are clearly other ways to try to achieve this, but Trump is going down the most politically incorrect path, by calling into question international trade agreements and imposing duties and tariffs on certain imported goods. This road is bumpy, because international partners are now turning into competitors who have no intention of standing on the sidelines.

One example is the recent introduction of China's duties against soy imports.

The move is directly aimed at hitting the US administration. In fact, it will likely damage soybean producers from the Midwest, an area that strongly supports President Trump and that is crucial for his chances of re-election. They export one third of their entire crop to China: about 14 billion dollars.

There would be a classier (and probably more effective) way to reduce the US trade gap, by using monetary policy.

Unfortunately, we can rule out this possibility due to the Fed's policy, which is essentially implementing a monetary tightening.

In fact, the higher the US rates, the stronger the US currency, which is frustrating the commercial strategies of the current administration.

Indeed, with such a big yield gap between T-bonds and other major global government bonds, the Fed is effectively providing an opportunity that institutional investors will seize sooner or later.

In fact, in a scenario of international trade warfare and protectionism, is it unreasonable to think that central banks worldwide are going to stock up on American government bonds causing an increase in the price of the dollar?

President Trump is a low interest rate guy

Before becoming president, Mr. Trump had repeatedly accused the American Central Bank to act politically by speciously keeping the interest rate low.

Now his opinion seems to have changed.

The point is that now, more than ever, the American administration needs to weaken the dollar.

"I don't like all of this work that we're putting into the economy and then I see rates going up." D. J. Trump

He can't be happy with seeing the dollar go up either, after all the effort being put against US commercial competitors

And, actually, the dollar looks quite weak today, if we consider all the things that are currently going on.

Bottom Line

Personally, I am not keen to consider Trump's recent criticisms of the Fed's monetary policy as a temporary tantrum.

The US administration simply cannot afford an economic slowdown in the next year, nor a strengthening of the dollar, and will do everything to avoid both: Including moral suasion of the Fed's board.

After all, the president of the United States appoints the entire board of the Federal Reserve, even though his picks must be confirmed by the Senate.

In light of these premises, the much-vaunted independence of the central bank appears to be a pipe dream, especially with a centralizing and hyper-decision-making personality like D. Trump's.

Those who are betting on a gradual weakening of the US bond market (NYSEARCA: TLT) due to a more restrictive monetary policy, together with a weakening of the stock market, should carefully consider this scenario.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.