Why the Federal Reserve cannot do much

There is tentative talk about Trump wanting to fire Fed chief Powell, which I don’t believe will happen. The consensus by pundits is that this will have serious negative consequences. From Forbes, How Trump Could Fire Powell And Rebuild The Fed:

And from Vox, Trump’s perhaps correct critique of the Federal Reserve, explained:
Premature interest rate increases hurt workers and the economy
, by Matthew Yglesias.

In agreement with Trump and Yglesias and owing to the fact I own stocks, I wish the fed would not raise rates anymore, but the fed is doing what it said it would do in late 2016, which is raise rates through 2019 until the 3% target is hit, provided there is no slowdown. Even though the stock market is near bear market territory, none of the data portends to recession yet. I agree the labor market has been weak for a long time. The low unemployment rate masks the fact that many people, especially young men, are not working. It’s so stupid when policy makers say that unemployed need learn better skills, as if that is some sort of elixir. Is that something you buy at Walmart “I would like an 8-pack of ‘skills’. Thank you.”

And inflation is persistently low in spite of the tax cuts, tariffs, and deficit spending, and a strong dollar puts further deflationary pressure on the economy by making imports cheaper.

What these articles have in common is they vastly overestimate the efficacy of the Fed. There is a common misconception, perhaps promulgated by the media, that the Fed controls the levers of the economy. No central bank has nearly that much power. If policy makers could create positive real growth at whim, they would.

Due to huge demand for low-yielding debt and a strong dollar, policy makers seem almost powerless to generate inflation as measured by CPI. Two years ago, many predicted trump’s policies would create inflation but the inflation never came, except only very briefly after he won and only a little. Same for Obama’s stimulus, which also failed to create much inflation. The only thing policy makers can do is stave off deflation and crisis, such as with bailouts like in 2008, but they cannot create much inflation. This is why the Fed is called the lender of last resort.

It is economic convention that raising interest rates makes borrowing more expensive, which should slow economic growth, but when rates are low, banks offset this by still charging a lot relative to the interest rate. That is why even in 2008-2010 when rates were at 0%, brokers were still charging 5-7% for margin loans. For more borrowing, and hence growth, to occur that gap needs to be narrow, which hurts bank profits and increases risk. This further limits the efficacy at monetary policy to create growth.

Furthermore, the Fed’s power is mostly limited to the short-end of the yield curve, and the fed has much less control over medium and long-term duration Treasury bonds. This means even if the Fed keeps the short-end at zero, the long-end will be significantly higher, which makes borrowing expensive. In 2008-2015, only the highest-grade borrowers such as multinationals could borrow at the short-end rate of the curve (0-2%). That is why 30-year mortgages were still above 6% during the recession even though interest rates were close to to zero. QE was an attempt by the Fed to manipulate the long-end of the curve by buying longer-dated treasury bonds after conventional monetary policy had been exhausted, with indeterminate success.

Whereas in the U.S. policy makers cannot create inflation, the rules change for foreign economies, especially emerging markets, and they are susceptible to stagflation no matter what central bank policy they adopt, in agreement with central banks being of limited efficacy. Such economies are dependent on external investment and commodities to have positive real growth. External investment allows foreign central banks to keep interest rates low without the side-effects of high inflation and falling currency. Without such investment, to spur growth, emerging market central banks must lower rates, but this create inflation and a falling currency, which negates any real growth even if nominal growth increases.

Because the U.S. dollar is the global ‘unit’ of wealth, the U.S. is in a very privileged position in that it can print money with impunity without a loss of wealth, whereas emerging markets lose wealth due decline of currency and rising inflation.

From the Forbes article:

You might think financial markets would freak out. I’m not so sure. Lower short-term rates combined with higher inflation expectations would steepen the yield curve, enhancing bank profit margins. Debt-driven industries from housing to autos might also benefit.

The long-term damage would be enormous. The U.S. dominates the global economy in part because we have stable, rule-driven institutions like the Fed. Letting politics openly drive monetary policy would remove the aura. Another central bank might rise to fill the Fed’s former role.

Again, I am not predicting any of this will happen. I’m saying it is possible.

Traders talk about “tail risks,” those remote possibilities that would have huge consequences. The odds Trump will fire Powell or other Fed officials are low, but well above zero. It’s more than a tail risk.

Yes, America is dominant due to monetary, geopolitical, and fiscal stability, but that is just one part. It also dominates mostly due to consumer spending, intellectual property, institutions and multinationals, innovation, and exports. Central banks help to some degree, but as discussed above, they cannot do much besides provide liquidity in crisis, and possibly create incentives or disincentives for risk taking by manipulating the short-end of the yield curve. They cannot create the next Google or a Facebook, nor can they create growth ex-nihilo.