As we know, President Trump’s not quite up with this economics stuff — but that’s okay, not everyone does need to know economics. Not even every politician needs to know, as long as they agree to know what they don’t know, which is where we might have a problem. As the president tweeted:
If the Fed had done its job properly, which it has not, the Stock Market would have been up 5000 to 10,000 additional points, and GDP would have been well over 4% instead of 3%…with almost no inflation. Quantitative tightening was a killer, should have done the exact opposite!
— Donald J. Trump (@realDonaldTrump) April 14, 2019
That’s not quite how it all works, no. It is true that there are two sets of economic policy levers, fiscal and monetary. The president and Congress get control of one set, the tax and spending side that make up fiscal policy. The Federal Reserve gets the other side, the interest rates and money supply that make up monetary. It’s even true that one can offset the other. Loose (that is, expansionary) fiscal policy can be counteracted by tight monetary. The idea that the opposite, that tight fiscal policy, can reverse the inflation of loose money creation is the central point of so-called “Modern Monetary Theory.”
It’s even true that the Fed’s quantitative tightening has offset some of the expansionary effects of Trump’s tax cuts and spending plans. So far we’re good then, except that doesn’t mean that the stock market would be higher without the Fed’s actions. Far from it.
The Fed is just doing its job, to set the overall condition of the economy to keep inflation and unemployment within the agreed limits. That is, if Congress and the president have loose fiscal policy then the Fed is supposed to tighten money to keep inflation at 2%. That’s actually the job description. So too, vice versa: If taxes are raised so high that they will slow the economy, then the Fed should loosen. This is so true that the economist Scott Sumner insists fiscal policy will always have no macroeconomic effect: the Fed will, and should, always offset it.
Which brings us to a central fact about stock markets: they are forward looking. They are the considered view about the future of everyone participating in those markets. As people are betting with real money, they’re as close as we have to a crystal ball about that future.
So, say the president and Congress enact a loose fiscal policy. The economy is already pretty much at full capacity. This is roughly where we were a year or two back. So, what will the markets do? Foresee that there is inflation coming down the road. At which point the Fed will raise interest rates to deliberately create a recession; that’s how we get rid of the inflation from the fiscal policy. That is, tax and spending designed to give the economy a boost can cause, through the Fed’s actions, a recession. Stock markets fall a lot if they think there’s one of them coming.
However, if the Fed raises rates a bit now to offset that macroeconomic stimulus, then we’ll not have inflation caused by it. No massive, crash inducing, rise in interest rates to come and thus the stock market is higher than without the Fed’s quantitative tightening.
It’s the very thing Trump is blaming for keeping the market low which is keeping it high.
It’s worth noting that apart from the most recent one, nearly all post-war U.S. recessions have been caused by the Fed trying to wring inflation out of the system. This isn’t something markets are going to forget.
We can make very good arguments that the economy could have used more fiscal stimulus than it got in 2008-2010. We can make milder ones to say that it didn’t need any stimulus in 2017-2018. That’s why the Fed had massively loose monetary policy with quantitative easing and more recently has tightened a bit, because of those Trump policies. Because that’s what they’re supposed to do — balance monetary policy against fiscal to get to the correct overall stance.
If they were to stop doing that, stock markets would be very much lower than they are.
Tim Worstall (@worstall) is a contributor to the Washington Examiner’s Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute. You can read all his pieces at The Continental Telegraph.
