Some are making the argument that the Federal Reserve Board could use a fresh perspective - one less rooted in academia and more in the real world. There are plenty of examples of how the "professor standard," as Herman Cain calls it, has led to illogical and potentially harmful decisions by the Fed.
Cain, the former presidential candidate who was being considered to serve on the Federal Reserve Board by President Trump, withdrew his name because of accusations of sexual harassment. But his point about appointing only academicians to the Fed is well taken. Consider some of the consequences:
- The Fed still relies on the Phillips curve, which predicts an inverse relationship between unemployment and inflation, in its decision making. The real world abandoned it during the 1973-1975 recession, when unemployment and inflation were both high. Today, we have low inflation combined with one of the lowest rates of unemployment ever recorded.
- Fed growth forecasts are almost always wrong. Throughout the Obama administration, the Fed regularly overestimated growth. Throughout the Trump administration, the Fed has regularly underestimated growth.
- The Fed set a 2 percent inflation rate as a seemingly arbitrary goal and used the need to reach this goal as a reason for continuing its zero interest rate policy (ZIRP). In 1979, when inflation spiked out of control, Congress mandated that the Fed bring the rate of inflation to zero within a decade. It never achieved that goal and it's never been clear why that goal was abandoned.
- The Fed regularly uses language no one understands. "Bond buying" becomes "quantitative easing," and when you reduce it, you're "tapering." Information about the Fed's future action is "forward guidance." The Fed also flirted with "macroprudential supervision," but abandoned the idea because apparently even the Fed didn't know what macroprudential supervision means.
- Potentially most damaging was the Fed's decision to purchase trillions of dollars' worth of bonds, boosting its portfolio from less than $1 trillion to $4.5 trillion. The Fed recently ceased its efforts to "normalize" its portfolio, because doing so was spooking the markets.
According to Cain, the Phillips curve, "the favorite tool" of academicians, "tells them wage growth that is too strong can cause an outbreak of 1970s-style inflation."
With wages rising at a rate of more than 3 percent a year, while inflation has been below 2 percent for four consecutive months, Cain argued in a Wall Street Journal commentary that the Fed should abandon the Phillips curve and instead focus on stabilizing the dollar.
"Since the Federal Reserve Act of 1913, there have been three distinct periods of sustained dollar stability: 1922-29, 1947-70 and 1983-99," according to Cain. "During these periods, real growth of gross domestic product averaged 3.9 percent a year and real income growth for the bottom 90 percent averaged 2.2 percent."
During periods of dollar volatility, he added, real GDP growth averaged only 1.9 percent and real income for the bottom 90 percent declined by an average of 1.3 percent annually.
The real world standard
Stephen Moore, an economic adviser to the Trump campaign who also favors dollar stabilization, also dropped out of consideration for one of the two vacant seats on the Federal Reserve Board.
That means the seats will not be filled by the president's first choices. Chances are high that they will not be filled with professors either, which had been the norm since Bill Clinton was president.
Moore, who played the lead role in the president's tax reform and deregulation policies, ran into trouble because of articles he wrote from 2001 through 2003 that women should be banned from refereeing, announcing or bartending at men's college basketball games. He said the articles were meant to be humorous.
He also was held in contempt for shorting his ex-wife by more than $300,000 for child support and alimony. Moore said that he maintains a friendly relationship with his ex-wife.
Moore accused CNN - where he used to work - and other media of "pulling a Kavanaugh against me" by bringing up articles he wrote many years ago, but even some Republican senators were reluctant to support his nomination.
Cain and Moore aside, three of the four Fed governors appointed to date by President Trump have not been academicians. Jerome Powell, who chairs the Fed, was an investment banker. Randal Quarles founded Cynosure Group, a private equity firm, and Michelle Bowman is an attorney who previously served as the banking commissioner of Kansas.
The only academician appointed has been Richard Clarida, the Fed's vice chairman, who was an economics professor at Columbia University.
Before Cain and Moore, previous nominees were approved with little opposition. That could change if the president is perceived as seeking nominees who will share his monetary philosophy. But why would any president choose candidates with whom they disagree?
Back to ZIRP?
One consequence of the Fed's continued reliance on the Phillip's curve is that it is currently not lowering interest rates, even though inflation remains in check.
During the Obama administration, the Federal Reserve Board held interest rates close to zero for seven years. The economy stagnated.
But now, with the benchmark federal funds rate at 2.25 percent to 2.5 percent after the Fed increased rates nine times, President Trump is advocating for the Fed to cut its key policy rate by a full percentage point and restart quantitative easing, buying bonds to lower interest rates.
The Fed has already made a policy U-turn, indicating in January that it is unlikely to raise rates at all during 2019, shelving its previous plan to raise rates twice (initially, three times) this year. It's not surprising that just four months later it's not ready to go full circle and lower rates. As expected, the Fed did not raise interest rates when it met on May 1. As expected, it didn't lower them, either.
In response, President Trump and the stock market sent the Fed a raspberry. The Dow Jones Industrial Average dropped more than 150 points after the Fed news conference, where Powell said that today's low inflation may be "transitory," CNBC reported, "dashing speculation the central bank was at least entertaining the idea of a rate cut because of tame inflation."
President Trump has called for lower rates, because he believes it would provide greater leverage as he negotiates trade deals with China and other countries. He's criticized the Fed for not accommodating his needs and there's some logic to his criticism.
During the Obama administration, ZIRP was accompanied by a historically high level of regulation and American corporations had the world's highest tax rate. Today, some of the regulatory burden has been lifted and corporate tax rates have been lowered.
Tax reform and deregulation led to increased business investment, which has driven stronger economic growth.
"Unlike the years leading up to the last recession," The Wall Street Journal reported, "the current economy isn't as dependent on the housing market. Many economists consider housing to be a form of consumption, while capital investment in equipment, intellectual property and new plants pays off for years to come in better productivity and higher wages. This is the tax-reform gift that keeps on giving as lower tax rates that are fixed in law raise the return on capital that encourages more investment."
While there are signs that business investment has been slowing, lower borrowing costs could cause business investment to re-accelerate.
Conversely, if rates are lowered and a recession comes, the Fed will lose a potential weapon for boosting the economy.
However, if President Trump really wanted to lower interest rates, he should have known that suggesting a rate cut would ensure that he would not get one.
When he practically ordered Powell to cut rates last fall, the Fed reacted by raising rates, causing a stock market swoon. The Fed is supposed to be politically independent and Powell likely doesn't want to appear to be following the president's orders.
Maybe President Trump should suggest a rate increase in a tweet before the next Fed meeting.
Brenda P. Wenning of Newton is president of Wenning Investments LLC in Newton. She can be reached at [email protected] or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.