What The Federal Reserve Should Be Doing

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by: John M. Mason
Summary

For 10 years the Federal Reserve had a goal and that was to underwrite the rise in the stock market to support the economic recovery.

Times have changed, but there is very little the Fed can do at this stage that would produce much faster economic growth. The supply side is driving the economy.

The Federal Reserve needs to keep calm, realize what it can't do, and work to keep markets functioning, supportive of what economic growth there is.

The Federal Reserve is right in the center of almost everything that is going on right now. And, it seems as if almost everyone, including the President of the United States, is putting pressure on the Fed to do his or her bidding.

It appears as if events are building to the point where the Fed is going to be faced with some choices, many of which are not at all desirable. The Fed is potentially facing a real dilemma.

For 10 years the Federal Reserve has underwritten the stock market advance, supporting it from one new historical high to another. The latest highs were reached Friday before last.

But it looks like the relationship between the Fed and the stock market may be moving into different territory.

The question is, what should the Fed be doing?

President Trump would like the Federal Reserve to lower its policy interest rate target further and faster than it has done. Yes, the Fed lowered the target rate for the federal funds rate last Wednesday, but the move was not great enough for the president.

The President would like faster economic growth. To him, right now, lower interest rates is the path to follow.

Mr. Trump would like to see economic growth in the United States break through the 3.0% level and stay there. After all, there is an election coming up in 2020.

Unemployment is at a 50-year low, and inflation is coming in less than 2.0%. To post an economic growth rate over 3.0% would be a winner.

The tax reform act passed in December 2017 and the reduction in regulation was supposed to get him there. But, it didn’t.

He at one time was going to propose an infrastructure bill. It hasn’t seen the light of day.

Monetary policy seems to be the only game in town.

The problem is, just how much can the central bank do to “goose up” the economy before the election?

There is a real question about what the Fed can achieve.

Over the past 10 years, the Fed has attempted to spur on economic growth by creating a wealth effect in the stock market that would provide the means for consumers to spur on the economy providing incentive for businesses to follow on by increasing spending on real physical capital.

The first part of this strategy worked. The Fed got its stock market boom - the wealth effect - and consumer spending has driven the current 10-year economic expansion.

But business capital spending remained limp. Productivity, especially the productivity of the labor force, did not follow on and economic growth remained tepid.

The rate of growth of the economy, over its history-making 10 years, achieved only a 2.2% compound rate of expansion. This is even including the impacts of the Trump tax reform bill.

This is the first bit of reality that we must face looking forward, the reality of what kind of economic growth can we achieve going forward from today.

The answer seems to be, we can expect little more than we have achieved over the past 10 years. As I have steadily written over the past several years, economic growth in the United States is really being driven by the supply side of the economy, and not the demand side.

There is a new economy “out there” and the supply side of the economy is going to dominate.

Estimates for future growth? The projections of the Federal Reserve, I believe, are as good as any other. The Fed expects the US economy to grow by 2.1% in 2019, 2.0% in 2020, and 1.8% in 2021.

The near-term future seems to be about as good as the recent past. And, this recent past included three rounds of quantitative easy and a willingness on the part of the Federal Reserve to provide a “put” under stock prices, a stance that contributed significantly to the market’s historic highs. The supply side just did not want to grow faster.

The condition of the economy puts everything else the government is doing or can do on the edge.

For one, the government’s debt situation is “out of hand!” The 2017 tax bill has resulted in budget projections showing trillion-dollar deficits for the near future.

The budget deal just cut by Congress just exacerbates the situation. Government debt loads are going to highs never before seen in peacetime. This puts tremendous limit on what the Federal Reserve will be able to do in the future.

On top of this we have more pressure to raise tariffs, putting even more pressure on the Chinese, but also spreading pressure to the Federal Reserve as Mr. Trump attempts to get the Federal Reserve to further lower interest rates.

Not only can the tariffs - and a possible trade war - be very harmful to the economy, but the very effort to force US interest rates lower creates a global environment where other major countries are considering lower interest rates to combat their slower growth rates.

The moves have resulted in a massive move of “risk-averse” funds throughout the world into safe-havens as uncertainty has soared world wide. These flows are putting tremendous strains on central banks throughout the world and this situation will put new, unknown pressures on monetary decisions, globally.

The Federal Reserve is being taken out of its fundamental responsibilities and being driven by the whims of political forces.

The economy, for the next few years seems, to be growing around a 2.0% level. Inflation appears to be stuck around 2.0%. Unemployment will remain below 4.0%, what was once considered to be full employment.

What more can be aimed for? What more can be achieved?

The Federal Reserve cannot do much more than it has been doing - giving confidence to investors that it is not going to pull the rug out from under the stock market. Already, money appears to be abundant throughout the world. There is not a scarcity of liquidity. Unfortunately, the Fed is going to be facing a lot more real pressure - from markets, but also politically.

The Federal Reserve must stay steady at the wheel and keep markets liquid. For now, that is about all it can do.

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.