Bad Economic Policy Trumps Monetary Policy

The Trump administration isn’t exactly known for doing things by the book, but insulting the person they hope saves them from their own policies seems especially strange. Then again, after asking “Who is the U.S.’s bigger enemy: Federal Reserve Chair Jay Powell or Chinese leader Xi Jinping?,” calling Powell “Mr. Too Late, a major loser,” isn’t the strangest thing the president has done in the past few months.

As many people have pointed out, publicly lobbying for the Fed to lower interest rates while also flirting with firing Powell isn’t exactly good for the Fed’s policy independence. And it’s probably not good for much of anything else, which might help explain why Trump quickly walked back the idea of firing Powell.

Whether the Fed should have policy independence is a debate worth having, and it might surprise some people to learn that Nobel Laureate Milton Friedman once called for putting the Fed under direct control of either the Treasury or Congress. He felt that doing so would likely increase the number of small policy mistakes, but prevent bigger disasters, like the Great Depression and major inflation. Regardless, he believed it was “intolerable that a group of nonelected people should have the power to create a major inflation or a major recession.”

The Fed is Not All Powerful

While there’s no shortage of people weighing in on this debate now, there’s another piece of the current chaos that few people are discussing: Can the Fed even do what Trump is suggesting?

Everyone, even the president, seems to assume that the Fed can just “lower interest rates,” but that’s not quite right. Yes, economists often say things like “the Fed lowered interest rates this month,” but that’s lazy phraseology.

For most of its modern history, the Fed’s main monetary policy tool was buying and selling government securities to influence the federal funds rate—the interest rate at which banks borrow overnight reserves from each other in the private market—toward a predetermined target. The theory was that by influencing the federal funds rate, the Fed could influence the rate at which banks were willing to make loans to their customers.

But there have always been good reasons to at least question how tightly the Fed controlled these relationships. For example, after following the federal funds rate up for two years, the Fed followed it down after September 2007, lowering its target FFR from 5.25 percent to 1 percent in roughly one year.

Why would rates exhibit this behavior if the Fed just “sets interest rates”?

The Fed Started a New Era in 2008

During the 2008 financial crisis, the Fed dramatically changed its operating framework by flooding the banking sector with reserves. The Fed still operates under this new “abundant reserves” framework, with which it alters the FFR by paying banks interest on reserves.

The theory behind this framework depends on banks being unwilling to lend to other banks at rates lower than the risk-free IOR rate that the Fed pays. So, now, the Fed’s main instrument for changing the FFR is changing the IOR rate.

Still, even under this new framework, private banks must make loans to increase economic activity. Similarly, when the Fed increases the IOR rate to push the FFR up, private banks still must cut back on lending if there is to be an economic slowdown.

As with the pre-2008 crisis monetary framework, there are many good reasons to question how tightly the Fed controls these relationships using the new framework.

For instance, in March 2022, the Fed raised its target rate for the first time in more than three years. As usual, the announcement was preceded by the usual debates over whether (and how much) the Fed should “raise interest rates.”

But while everyone was busy arguing about how aggressively the Fed should act, short-term interest rates were busy forcing its hand. The 3-month Treasury was 0.05 percent in November 2021 but ended February at 0.33 percent. From February 1 to March 15, the rate on overnight nonfinancial commercial paper doubled, rising from 0.16 percent to 0.33 percent. The one-week financial commercial paper rate followed nearly the same path.

Weak Treasury Demand Moved Rates

More recently, in the wake of the administration’s chaotic trade policy rollout, Treasury security auctions did not go as expected, with weak demand pushing rates up higher than everyone expected. As multiple news accounts explained, fluctuations in private demand—for all sorts of reasons—outweighed the Fed’s moves.

On a good day, most economists readily acknowledge that the Fed cannot just make “interest rates” whatever the Fed chair, or even the Federal Open Market Committee, wants them to be. What the Fed does is more complicated than what most news stories imply, and that’s partly out of necessity. News stories are not textbooks.

Nonetheless, the Fed does not simply control our economy’s “interest rates.” It does try to tighten or relax credit conditions based on its macroeconomic goals, but there is no guarantee that the Fed’s operations will lead to a precise change in lending. More broadly, there is no guarantee that the Fed’s rate policy will lead to a precise change in the overall money supply, interest rates, prices, unemployment, or overall economic activity.

The Fed Can’t Fix Supply Shocks

In some cases, like a negative supply shock induced by a trade war, there will be little that monetary policy can do. The shock causes goods to disappear from shelves and sends prices higher. Even if the Fed could “raise interest rates,” it would merely make credit scarcer, doing nothing to help people buy the products they want.

Fortunately, at least some of the people running America’s largest retailers seem to understand this problem. They’re not badgering the Fed to lower interest rates. They’re imploring President Trump to reconsider his tariff policy, warning him that if he doesn’t reverse course, it “could disrupt supply chains and lead to empty shelves in the coming weeks.”

The people who run the Fed are not perfect, and in many respects, they have an undesirable job. But Americans should not scapegoat Jerome Powell for the administration’s tragic trade policy mistakes.