Saturday 21 September 2019

Karl W Smith: 'Fed cannot intervene in elections, but should talk about Trump's trade war'

Trade tension: The Federal Reserve could be forced to respond to
the US-China tariff war. Photo: Bloomberg
Trade tension: The Federal Reserve could be forced to respond to the US-China tariff war. Photo: Bloomberg

Karl W Smith

The US Federal Reserve has responded to the suggestion that it wade into presidential politics in the only way it could: with a forceful denial. The Fed's decisions "are guided solely by its congressional mandate to maintain price stability and maximum employment", said a spokeswoman.

"Political considerations play absolutely no role."

The statement is admirably direct. Still, it is not enough.

Chairman Jerome Powell has no choice but to speak out to defend the Fed.

And it's not just about politics. As my colleagues have noted, the idea that the Fed should interfere in a presidential election violates not only the body's independence but the spirit of democratic governance.

To stand pat in the face of a trade war is misguided on economic grounds as well.

In macroeconomic terms, US president Donald Trump's trade war with China is akin to an oil shock. The US has experienced several politically generated oil shocks in its history, and there has been a lot of deep thinking about how to handle them.

Prescriptions differ. But the nearly universal consensus is that the Fed should attempt to fully offset the impact of this type of shock by lowering interest rates and increasing demand.

Doing so would have the effect of exacerbating the price increases associated with the shock.

These price increases would be temporary and mild, however, compared with the effects of trying to keep prices stable.

The only concern with such a strategy is that it could cause inflation expectations to rise, making it more difficult for the Fed to meet its goals for price stability.

That is not a problem at the moment, as the Fed is battling inflation expectations that are too low and declining.

In the current climate, then, raising inflation expectations is a benefit, not a cost.

So while there are practical difficulties with managing the unpredictability of the economic shock from a trade war, it is clear what the appropriate response should be: that the Fed should accommodate the shock fully, even if it leads to a temporary spike in inflation.

For the sake of the Fed's future credibility, Powell needs to make a statement about how the body sees its job going forward.

To his credit, Powell has mostly ignored the president's comments about the Fed and reiterated that the bank will make every effort to keep the current economic expansion going.

At the same time, he has noted, correctly, that the trade war presents new challenges for the Fed.

Now, Powell should go further and explain that it is part of the Fed's role to mitigate the effects of supply shocks - regardless of their source.

Doing so not only supports the Fed's independence, but it is also good monetary economics.

Bloomberg

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