WASHINGTON. To help the economy get out of the 2008-2009 Great Recession and move quickly through recovery into an expansion, Washington’s Federal Reserve Bank massively increased the nation’s money supply. The Fed also drastically cut interest rates to near zero. This was done through a series of policy actions known as quantitative easing (QE).
Interest rates began to fall in 2008. By the end of 2009, the federal funds rate had fallen from 3.5% to 0 .25%. By 2010 or 2011 the economy should have fully recovered from the deep recession. Instead, the recovery was very tepid. It proved to be the weakest recovery since the Great Depression.
How the Fed normally treats a recession
Historically, if a recession is deep like the one the U.S. experienced in 1979-1981, the economy generally comes roaring back. That’s what happened by 1984 when annual U.S. economic growth hit 7.5%. Yet even with an extremely expansive fiscal policy that saw annual deficits exceeding $1 trillion, the Fed’s monetary policy actions failed to significantly increase economic growth during the Obama administration. In fact, that administration regularly explained to us that 2% annual economic growth was the new normal.
The Fed’s policy did help to end the recession. But without much help from Congress or the Obama administration — both of which had other priorities — the Fed could never get the economy into the expansion phase. The reason was, in 2010 Congress passed the Dodd/Frank bill, which was intended to end predatory lending. It accomplished that. But because of vastly increased regulations, it also ended most other kinds of bank lending.
If banks are not lending money, there is no multiplying effect on money created by the Fed’s actions. The result was a small increase in growth. On the plus side, there were also small increases in prices.
Trump reverses Obama Era low growth policies, Fed goes on alert
President Trump has set economic growth as his top priority. Since he canceled hundreds of counter-productive regulations imposed through an executive order by the prior administration, the economy quickly accelerated, growing initially at a 3% rate. Since April 2018, thanks to the Trump tax cuts and the repeal of portions of Dodd/Frank, the American economy has been growing at more than a 4% rate.
Growth for the current quarter will be estimated at the end of this month. It is likely to show that the economy is growing at more than a 4% rate. Some economists and the Fed believe that growth rate could go even higher next year.
While the Fed would like to see a higher rate of growth, the central bank’s traditional concern is inflation. After a series of eight rate hikes over the last 2 years, the federal funds rate is now up to a targeted 2.25%. The Fed must now decide how much higher to raise rates and how quickly that should be accomplished.
Many Fed officials want to aggressively raise interest rates to ensure that inflation does not become a problem. Since President Trump has set economic growth as his top priority, however, he would like a more accommodative monetary policy. That means raising interest rates slowly and only after the economy records more high growth rate quarters.
Which policy is the right one?
Most economists would likely side with the Fed. These economists look back at the 1970s and see a time when inflation grew at an alarming rate. That led consumers into an inflationary psychology. This, in turn, led to even more inflation. Consumers would often rush to purchase goods simply because they believed prices would soon be much higher. That logic invariably helped lead to rising prices.
Inflationary psychology is difficult to reverse and could possibly wind up leading to runaway inflation. So any hint of rapidly rising prices, it is thought, should be dealt with sooner rather than later.
Trump’s economists argue differently. They believe that the U.S. economy can grow at higher rates without triggering inflation. Essentially, they believe that inflation is mainly caused when the total demand in the economy exceeds the business sector’s ability to supply consumer demand.
They further argue that Trump’s economic policy is modeled after President Reagan’s supply-side oriented economic policy. Trump has eliminated counterproductive regulations, reducing tax rates for all Americans including corporations. Both are similar to Reagan’s actions in the 1980s.
The Trump/GOP tax cut effect
Because Trump cut taxes for the highest income earners, new capital is being created. And because Trump cut taxes for corporations, considerably more new capital will be created. Since the U.S. is a capital-intensive economy, the new capital will give businesses the ability to increase supply to meet the new demand. The result: there will be little if any inflationary pressure.
In the 1980s, the U.S. economy experienced continued high growth and low inflation. President Trump says that can happen again.
Trump also recognizes that his aggressive international trade policy may result in some downward pressure on growth. But he is putting in place tough new policy positions now with the goal of rewriting all the international trade agreements that are slanted in favor of our trading partners while functioning to the detriment of the U.S. economy and its workers.
Within the next year or so, the President expects to have all these trade agreements re-written so that foreign markets are finally opened to U.S. businesses both now and well into the future. Until that happens, however, Trump doesn’t want to see the Fed get too aggressive with interest rates, possibly slowing economic growth.
It looks like Trump is right again. Last month the annual inflation rate fell slightly. Since the economy is finally entering an expansion stage, it is simply too early for the Fed to get aggressive with interest rates.