Trump forced the Fed to raise rates. The results could be ugly.

Summary: Trump’s unexpected election forced changes in the forecasts and plans of the Fed’s leaders. Today’s decision to raise rates is their first result. Janet Yellen was quite candid about this. The implications of the rate rise are complex. The effects might prove calamitous.

Janet Yellen
Brendan Smialowski/AFP/Getty Images

Janet Yellen’s remarks at the press conference

She clearly pointed to Trump’s plans for a combination of tax cuts plus large increases in infrastructure and military spending. The Fed’s leaders have obviously been thinking about the effects of the resulting massive deficits — and decided to preemptively strike against them.

“…We’re operating under a cloud of uncertainty at the moment, and we have to wait and see what changes occur and factor those into our decision-making as we gain more clarity,”

“…Changes in fiscal policy or other economic policies could potentially affect the economic outlook. Of course it is far too early to know how these policies will unfold. Moreover, changes in fiscal policy are only one of the many factors that can influence the outlook in the appropriate course of monetary policy.”

“…There may be some additional slack in labor markets, but I would judge that the degree of slack has diminished. So I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment. But nevertheless let me be careful that I am not trying to provide advice to the new administration or to Congress as to what is the appropriate stance for policy. There are many considerations that Congress needs to take account of and many bases for justifying changing fiscal policy.”

“…Our decision to raise rates should certainly be understood as a reflection of the confidence we have in the progress the economy has made and our judgment that that progress will continue. …It is a vote of confidence in the economy.”

“…We want to feel that if the economy were to suffer an adverse shock that we have some scope through traditional means of interest rate cuts to be able to respond to that.”

From Reuters. Also see Yellen’s opening statement at the press conference.

Rising Interest Rates

Investors raised rates before the Fed acted

Investors immediately raised interest rates after the election. See Freddie Mac’s graph of 30 year mortgage rates (as of December 15). Click to enlarge.

Interest rate on 30-year mortgages -15 December 2016.

Why is the Fed so eager to raise rates?

We can only guess at the various reasons, and the weight of each in the calculations of the Fed’s governors. They want to build a rate cushion, so they can cut rates in response to the next recession (that’s not so smart if their rate increases help cause the recession). Some of the governors are inflationistas, who always see inflation under their beds. The Fed has traditionally been the big banks’ servant, and they want higher rates to boost their profit margins.

One reason we can rule out: evidence of an acceleration in economic growth. The forecasts of the Fed staff predict a continuation of the 2% GDP growth of 2011-2015: 1.9% in 2016, 2.1% in 2017, 2.0% in 2018, and 1.9% in 2019. That is logical since almost every indicator of economic activity remains stagnant, except for those that are slowing.

Effects of the rate increase

Paul Krugman, as usual says it well.

“So the Fed has raised rates. It was, I’d argue, a mistake, although not as severe a mistake as it would have been a year ago. Anyway, it seems like a good time to review where I think the economy stands, and what it means for monetary and fiscal policy.

“At this point, the evidence does suggest that we’re close to full employment. It’s not so much the headline unemployment rate, which is questionable given low labor force participation. But wage growth has accelerated {no; see below}, and the quit rate is back more or less to pre-crisis levels, suggesting that workers feel pretty good about job prospects.

“…But what if we are about to get significant fiscal stimulus from Trump? Well, it won’t be well-targeted, in terms of either demand or supply; that infrastructure build looks ever less likely, so we’re talking high-end tax cuts with low multipliers and little supply-side payoff. Such a policy might vindicate the Fed’s rate hike, but it should still wait and see.

“Meanwhile, Trump deficits won’t actually do much to boost growth, because rates will rise and there will be lots of crowding out. Also a strong dollar and bigger trade deficit, like Reagan’s morning after Morning in America.”

Update: About those rising earnings, see today’s BLS report. As of November, real average weekly earnings in the private sector have risen 0.5% YoY. That’s a large drop from their 1.7% YoY growth in November 2015. Growth is slowing, not accelerating: up in only two of the past eight months.

Krugman assumes that Congress will approve Trump’s plan. I suspect that is unlikely.

Effects on the economy

The US and global economies have proven themselves astonishingly resilient to shocks since the 2008 crash, although hooked on repeated bouts of fiscal and monetary stimulus. Trump’s victory has sent stocks soaring and bonds falling (long rates rising) on expectation of massive fiscal stimulus — and faster economic growth. Now the Fed has joined the party, boosting short rates.

The likely results are slowing growth from higher rates and a stronger dollar. Further rate increases will prove even more destabilizing, but the prospect of skyrocketing deficits and a overheating economy might push the Fed to do so anyway.

For More Information

For more information about Trump’s budget based on what we learned during the campaign, see “Promises and Price Tag” by the Committee for a Responsible Federal Budget, 22 September 2016.

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10 thoughts on “Trump forced the Fed to raise rates. The results could be ugly.”

  1. That’s a kinder view of the Republicans than I have. The Republicans in this Congress never saw a tax cut they didn’t love. I think they’ll pass the infrastructure plan becsuse it’s just a big tax cut in disguise, in addition of course to all the other tax cuts And as soon as Democrats are out of power, deficits stop mattering, like the examples you gave of Reagan and Bush II.

    1. Camilla,

      “That’s a kinder view of the Republicans”

      I don’t see either of our views as being “kind” or not. Trump seems likely to force Republicans to choose between two core values: a balanced budget and lower taxes. Such choices are difficult for anyone.

      “I think they’ll pass the infrastructure plan becsuse it’s just a big tax cut in disguise”

      I don’t believe that is an accurate way to describe tax credits for investments. It’s true only if the rich guy were going to make that investment even without the tax credit — so the credit just reduces his taxes — which is not the case with infrastructure spending.

      “out of power, deficits stop mattering, like the examples you gave of Reagan and Bush II.”

      Yes, that’s the history. But unlike those examples, the GOP — and the Right — have spent 8 years hysterically warning about the coming doom from Obama’s deficit spending. I wonder if even conservatives can flip-flop that boldly and quickly.

      As a hint — nothing more — a few voices have been raised against Trump’s plans: “McConnell, Warning of ‘Dangerous’ Debt, Wants Tax Cut Offsets“.

  2. We are stuck in a low growth environment. What alternatives do you suggest? Even Keynes acknowledged the importance of “animal spirits” in driving the economy forward and Trump is all “animal spirits”.

    1. Bernie,

      Keynes discussed “animal spirits”, a phrase with a long history in Western thought (see its Wikipedia entry). It refers to individuals’ psychology.

      You use it in a different sense of the leader inspiring people to act by transmission of his will. There is no evidence that this happens. It’s an exaggeration of the “bully pulpit” — itself a bogus concept (see this by John Sides, assoc prof of pol science at George Washington U).

  3. Lead by example worked for Teddy Roosevelt.. For all Trump’s bluster, missteps, foibles and crassness, nobody can question his astonishing energy – especially the sharp contrast to the lack of or compromised energy of Clinton and the apparent somnolence of Obama.

    I lived through the soul destroying 60s and 70s in the UK. Thatcher shook things up and despite some of her gross errors forced Britain out of its economic doldrums.
    Leading a Nation State is definitely more complicated than leading a large company, but both require somebody with energy and the will to act when there is a need for systemic change. IMHO, the hope and change mantra just hasn’t and can’t cut it.

    As for interest rate hikes, I am a saver/retiree and see them massively overdue and reflective of our anemic economic growth rate and an ongoing transfer of income from savers to borrowers.. I personally have had to delay all kinds of high multiplier expenditures because of the impact of low interest rates on my income. Real economic growth is the key.

    1. Bernie,

      The question of the President’s ability to influence the public by his speeches has been extensively studied. There is no basis to believe it has any meaningful effect. It’s an urban legend.

      “Lead by example worked for Teddy Roosevelt.”

      Evidence, please. That sounds to me like a myth.

      “For all Trump’s bluster, missteps, foibles and crassness, nobody can question his astonishing energy”

      Energy is only useful for a leader doing right things. It’s destructive in one doing wrong things. Prussian Field Marshal Helmuth Karl Bernhard Graf von Moltke (1800-1891) developed this matrix to describe his officers.  It clearly shows that “energy” is useful only when combined with other useful traits. Also, we don’t know if Trump applies his energy to the routines of President, or if he will be lazy with regard to duties that aren’t fun.

      Time will tell which box best describes Trump. Click to enlarge

      Von Moltke's attribute matrix


      “of low interest rates on my income.”

      Not the Fed’s fault. Despite the urban legends, economists have repeatedly explained that the Fed is not suppressing interest rates, and hasn’t been for years. Details here.

      “Real economic growth is the key.”

      Too bad that wasn’t an issue in the campaign. Too bad that massive tax cuts for the rich have repeatedly proven themselves ineffective at boosting growth. Too bad for America.

  4. The Fed has wanted to raise interest rates (for both good and bad reasons) for years but have not because they have correctly responded to the pressures on the economy. One of the byproducts of their desire is that they frequently talk up how well the economy is doing and how they are going to need to normalize interest rates soon but they rarely do so when the time comes. And they are usually right not hold interest rates steady.

    I will believe that they are going to raise interest rates 3 times next year if the second rate hike occurs before October. Last year they said that they were going to raise interest rates four times in 2016 and raised them once.

    1. Pluto,

      “I will believe that they are going to raise interest rates 3 times next year if the second rate hike occurs before October.”

      Predicting such things is beyond the state of the art. People on Wall Street do so for the same reason bookies tout horses at the track and astrologers create horoscopes: there is a demand for such things.


      Einstein dies and goes to heaven. St. Peter says that his room is not yet ready. “You will have to share the room with others for a while.” St. Peter lists his roommates.

      “Bob is a nice man; he has an IQ of 130.”
      “That’s wonderful!” Einstein replies. “We can discuss my theory of relativity.”

      “George has a charitable heart; he has an IQ of 100.”
      Einstein replies “That’s wonderful! We can discuss the prospects for world peace.”

      “Your third room mate, Sam, is a warm and wonderful person — but has an IQ of 80.”
      Long pause. “We can discuss where interest rates are going.”

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