Have you ever met an individual who wanted to pay a higher interest rate for a loan such as a mortgage? Of course not. The reason is simple - we’d all rather pay less interest rather than more when borrowing money. Now, instead of a private home mortgage, imagine you were borrowing for a large-scale real estate project that was in the tens- or even hundreds-of-millions of dollars. In such a case an even small difference in interest rates could mean many millions of dollars of additional interest owed and could be the difference between your project being profitable and being in the red.
So, given President Trump’s background in real estate it should not be surprising that earlier this year he aggressively chastised the Federal Reserve (Fed) for not doing enough to help the economy - namely not lowering interest rates.
The Federal Reserve is an entity that acts independently of the President or any governing body for that matter. Famously, not even Congress dares to audit the Fed, as every attempt to bring a bill forward that would do so has gone down in flames.
While the Federal Reserve is ostensibly independent, this isn’t the first time the Fed has been pressured by a sitting president to see things their way. Lower rates make the economy seem better and makes voters feel richer, thereby improving the incumbent’s chances of re-election or of their party continuing to control the White House. The opposite is also true, high rates and/or a stagnant or contracting economy tends to scare voters - often enough to make them cast a ballot for the opposition. Interest rates are a powerful tool - both monetarily and politically.
Federal Reserve Chairman Jerome Powell shrugged off the President’s criticisms this summer reminding everyone that the Fed answers to no one. At the next Fed meeting interest rates were cut 25 basis points or 0.25% and then again by the same amount at the September meeting. Whether the President was able to influence the Fed into taking this action or not we’ll likely never know, but the fact of the matter is President Trump got what he wanted - lower rates and therefore an economy that continues to hum along - hopefully, at least for him, through the 2020 election.
Understandably, some people may be skeptical that the Fed Chairman and President Trump just happened to coincidentally see things the same after a very public spat. Of these people there are largely two separate groups. The first group thinks that the Fed is now in the pocket of the executive branch and will continue to do as they are told. The second group is equally confident that the Fed is actively working against the President to undermine him in the 2020 election by either raising rates at an inopportune time or failing to cut rates further after markets come to expect it. This would have the effect of panicking voters and possibly decreasing the chances of a successful re-election.
Regardless of whether you think the Fed is working with the President, working against him, or doing what they should be doing- acting entirely independently based solely on the data available to them, is largely irrelevant. By cutting interest rates while they were still at historically low levels, the Fed may ultimately be shooting themselves, and the economy, in the proverbial foot in the long-run.
Those that have been monitoring the markets for some time will recall the recession that resulted from the bursting of the tech bubble at the turn of the century and who could forget the great recession, where the entire economic system was seemingly on the verge of collapse, if cable news was to be believed. Both of those recessions were no doubt difficult - particularly for those who found themselves out of work, underwater on their homes or otherwise financially imperiled. In both instances the Fed quickly and drastically cut rates to cushion the blow, but even with these actions we all felt the effects of recession.
When the tech bubble burst, the Federal Reserve cut interest rates a total of 550 basis points or 5.50%. During the great recession rates were cut 500 basis points or 5.00% and they would have likely cut more had the Fed not run out of room. Because of the widespread nature of the effects of the housing bust, the Fed also took other unprecedented actions such as organizing bailouts of banks and taking on toxic debt that issuing banks could not keep on their books in an effort to stop the bleeding.
Today, using government data, inflation is relatively low, unemployment is also low. Inflation and employment represent the Fed’s dual mandate. Despite these metrics being in line with the stated goals, the Fed still saw fit to cut interest rates twice so far this year and may be considering doing so again going forward. While other factors do play into the Fed’s decision, such as the relative strength of other economies there is, seemingly, little to worry about with regard to our economy - at least insofar as the top-level numbers are concerned.
This last recession forced the Fed to cut rates to essentially zero. Interest rates were so low that money market funds were forced to cut their fees so that investors didn’t go negative when trying to preserve principal. The resulting historically low interest rates have stayed with us for the last decade as the economy has slowly recovered and the Fed started to shed some of those assets from their books.
Looking ahead to the next recession which could be happening now or starting at any point in the future, it is easy to see that the Fed simply does not have the dry powder necessary to deploy their best and most effective tool - interest rates - when, not if, that recession hits. In an effort to keep the economy moving forward today, we may have seen the Fed create an inability for them to properly deal with a future downturn because interest rates are artificially low and have been recently made lower still.
If the next recession requires 500 basis points, or more, of interest rate cuts, the Fed will be unable to oblige and that means the risk of the next recession being deeper and longer than the most recent two is a very real threat.