Is The Fed Right About Hiking Rates?

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by: Epoch Times

The timing and the rhetoric are strange, but the Fed is thinking about the long term.

President Donald Trump isn't a fan of current Federal Reserve policy, specifically about raising rates too fast or too much.

And it is true: the timing of the rate hikes and the brisk commentary coming out of the Marriner S. Eccles building in Washington seem odd to many who have gotten used to continuous Fed support for financial markets, whether in the form of jawboning or various easing programs.

We all remember how Janet Yellen all but suspended the intended tightening policy just before the presidential election in 2016 because of market jitters. So, Trump is right to wonder why the current incumbent administration does not get the same treatment from the Fed as the previous one.

However, leaving the political timing aside, current Fed chairman Jerome Powell's policy is the right one for America in the long run.

Lost Opportunity

As Trump noted himself, the mandate of Yellen in the Fed was a lost opportunity. Yellen and the Fed delayed urgent and justified rate increases despite a bull market and high liquidity due to the fear of a negative market reaction ahead of the 2016 election.

And it's not that Powell is acting rashly. His Fed is conducting the rate hikes with months of warnings and detailed communication. Because the economy is growing above 3 percent, wage growth is also at 3 percent and unemployment is at record lows.

The rate hikes so far have not only caused no damage to the economy but have helped strengthen growth while investment returned.

Years of low rates reduced capital expenditure and fueled a dangerous bubble. Now, real investment is back. Gross fixed capital formation is up 8 percent this year after years of stagnation, and capital repatriation exceeds $300 billion.

The reason why Powell can and should use this period of superior growth to build a buffer for the future is because the Tax Cut and Jobs Act has helped prolong the recovery, which has started to reach the middle class. Savers and workers benefit from a stronger dollar and moderately higher rates. Now, as the interest rates on even the shortest-dated and safest Treasury bills are above 2 percent, conservative savers are starting to see their disposable income and savings improve.

Easy Fed Money

It is important to note that policy remains highly accommodative compared to historical standards. The yield on 30-year U.S. Treasuries discounting inflation is less than 0.08 percent, and credit conditions remain robust. Money supply growth continues to be strong and above nominal GDP growth despite the Fed reducing its exposure. The private sector is offsetting the unwinding of the Fed's balance sheet.

More importantly, if the Fed does not build a buffer for an eventual downturn by reducing the balance sheet and raising rates while the economy is strong, the negative consequences will be significant.

We see in Europe how the European Central Bank (ECB) has not raised rates, and now the slowdown of the second half of 2017 has accelerated, leading the central bank to exhaust all its tools to support the economy.

If there is a possible recession, what can the ECB or the Bank of Japan (BoJ) do when rates are at all-time lows and liquidity at all-time highs? Very little.

And while the Fed is getting prepared for an eventual downturn, it is precisely the positive effect of this administration's supply-side measures that keeps jobs, wages, investment, and growth above global trends.

Strong Dollar

The U.S. dollar needs to remain the world reserve currency and the safest asset, and this can only happen if the Fed normalizes its monetary policy as it has announced.

The United States can absorb the rate hikes because the evidence shows it becomes a safer and better investment option compared to the rest of the world. And even though the S&P 500 has recently dropped sharply and is 10 percent off the record highs, European markets trade 20 percent below their 2015 highs, which never reached the 2007 highs, which never reached the 2001 highs.

As the U.S. economy improves and others face the saturation of past stimuli, it is only logical that the United States sees a high inflow of funds from abroad. And that is good. It keeps U.S. Treasury yields low, stimulates demand for bonds and equities - at least relatively speaking - and provides a steady flow of capital investment into the U.S. economy.

The U.S. economy can accept a strong dollar and moderately higher rates. It only exports around 10 percent of GDP, and less than 30 percent of the profits of S&P 500 companies come from exports. More importantly, the United States exports high value-added goods and services, which don't suffer much from a stronger dollar.

In the past nine years, devaluing the currency and lowering rates has hurt the middle class, savers, workers, and high-productivity companies - those that voted for Trump to change the mistakes of the past. A devaluation policy hurts more Americans than it helps. Devaluation is simply stealing from your citizens' savings and disposable incomes.

A strong U.S. dollar reduces inflationary pressures and keeps interest rates low. With the economy growing as it is today, rates would be much higher in a normalized environment, closer to 4.5-5 percent.

A strong dollar and a prudent monetary policy have those two positive effects for savers, workers, and families as the economy strengthens and wages improve.

Signal Effect

If the Fed did not raise rates as announced, it would send a negative signal to the world - that things are much worse than the economic data shows. Even worse, it would not act as a positive driver for risky assets like stocks and bonds.

These are falling now because of excessive valuations and the slowdown in emerging markets and the eurozone, factors that have nothing to do with the Fed's normalization and everything to do with the excessive fiscal and trade imbalances built by those economies in the period of low rates and high liquidity. As noted above, those markets are down much more than the S&P 500.

The Fed needs to normalize in order to avoid making the mistakes of the ECB and the Bank of Japan, but mostly to maintain the status of the United States as the world reserve currency.

A sound monetary policy and defending a strong currency is good for the clear majority of the economic agents of an economy. No country has collapsed due to a strong currency. Many have fallen due to constant destruction of the purchasing power of their currency.

A moderate rate hike policy and a strong currency are also essential to keep the world reserve currency status. If a small proportion of the U.S. economy suffers from a strong dollar due to low competitiveness, it is a price worth paying in exchange for being the world's most used currency, a reserve of value, and a worthy investment for the rest of the world.

If Trump wants to strengthen the domestic market, increase disposable income for the middle and lower classes, and end the perverse incentives created by years of excessive demand-side policies, he needs to accept the prudent path outlined by Powell.