June 27, 2019 606 PM
THE MONEY MAN
President Trump regularly calls out the Federal Reserve Bank for its interest rate hikes from 0.5% to 2.5% during his presidency. He fears that rate increases could bring a recession, jeopardizing his reelection bid. They could and it might, but it’s largely beyond his control.
To start, the law assigns the Federal Reserve Bank two jobs, which are to keep both unemployment and inflation low. It has one tool, the ability to set interest rates for banks to borrow from the Fed. Cutting Fed interest rates makes it cheaper for banks to borrow from it and lend. This “creates money,” because the Fed is the “lender of last resort.” It can lend no matter what, which is crucial in bad times. More lending and borrowing—more credit—fuels economic activity, which lowers unemployment.
Plus, the law makes the Fed independent of the three branches of government, and traditionally presidents leave it alone except when deciding whom to appoint to the Federal Reserve Board of Governors and then select as chair and vice chair. Trump is not (surprise!) following tradition, blaming his own appointee Chairperson Jerome Powell for raising rates and threatening the current expansion, low unemployment, and high stock market.
This is how it works. Say that an enterprising Marfa student starts Shorthorn Lemonade Stand, Inc. Business is good, so she wants to expand from one stand in front of the City Hall to another by the Courthouse (with permits, of course). She can either save up profits and wait until the day Shorthorn has enough cash in its checking account to set up a new stand, or she can borrow to do it all now. Borrowing is a bet that extra income (income minus expenses) from the new stand will more than cover the loan payment.
The company can use the borrowed money to purchase lumber and paint, hire more salespeople, buy more lemons, sugar and cups, and advertise in the influential Big Bend Sentinel today. That stimulates the economy. This is how one loan, in the hands of good businesspeople (not all are, because capitalism has winners and losers), multiplies each dollar, which economists call the “velocity of money.” Loose credit—low interest rates making it cheap to borrow—fuels growth and expansion through a faster velocity of money.
But when an economy heats up, more money chases fewer goods and services. Everyone is doing well, they all want to spend their money, and it’s basic economics that when demand is higher than supply, sellers can increase prices. That’s inflation. This is where the Fed, in the classic phrase, must be the chaperone who takes away the (spiked?) punchbowl (low rates) just when the party’s (booming economy) getting started. Tight money—higher rates making it expensive to borrow—restrains growth and expansion. No new Shorthorn Lemonade salesperson is hired, no supplies ordered, no new lumber and signage purchased. The velocity of money slows. This is what scares Donald Trump. Higher rates could slow any growing inflation, sure, but it could kill the economic party and hurt his reelection chances.
Presidents like Trump should save their breath (as if that will happen). The Fed has a reputational interest in acting independently and doing its best to reduce inflation. The system needs to have confidence it will do its job regardless of political pressure. Sure, Chairperson Powell did do an about face in January and has kept rates steady all year, but it was certainly based on the mountains of data he and his hordes of economists review—not the president.
Despite claims otherwise, presidents don’t really have any control over the economy—except for example when pursuing dangerous tariffs, as Trump is doing. Rates rise and rates fall. This is the Fed doing its job. Politicians like to complain for their short-term benefit, but long-term investors don’t have to care. We know that lemonade stands as a whole survive easy money and tight.
Tom Jacobs is a partner with Huckleberry Capital Management, a boutique investment advisory fi rm serving clients in 25 states and 3 foreign countries from offi ces in Marfa, TX, Silicon Valley, CA, and Asheville, NC. You may contact him at 432-386-0488 and [email protected].