How politics is intruding on Fed policy

Posted by Cam Hui -

Recent U.S. economic data has generally been weakening, as evidenced by the decline in the Citigroup Economic Surprise Index (ESI, gold line), which measures whether economic data is beating or missing expectations. As ESI has been roughly correlated to bond yields, this should put downward pressure on rates and expectations of rate cuts in the near future.
 

 

Not so fast! Fed policy has become increasingly constrained by politics, both on a short- and long-term basis. Here’s why.
 

 

Reasons to cut rates

Here are the reasons to cut rates. The market has seen a series of tamer inflation readings, as measured by core CPI (blue bars) and core PCE (red bars). CNBC reported that Fed Chair Powell sounded dovish during a European Central Bank forum in Sintra, Portugal, though he refused to commit to a September rate cut.
“We’ve made quite a bit of progress and in bringing inflation back down to our target,” Powell said at a central banking forum in Sintra, Portugal.
 

“The last [inflation] reading and the one before it to a lesser extent, suggest that we are getting back on the disinflationary path. We want to be more confident that inflation is moving sustainably down toward 2% before we start the process of reducing or loosening policy,” he added.

 

 

As a reminder, Powell had set out the tripwires to rate cuts at the last FOMC press conference, namely better inflation readings or a cooling employment market. Headline June Nonfarm Payroll came in slightly ahead of expectations, but the April and May figures were revised down. More importantly, leading indicators of employment, such as temp jobs and the quits to layoffs rate, are weakening.
 

 

In addition, a mechanical application of the Taylor Rule based on a 2% inflation target and 2% real rate, shows that the Taylor Rule rate (blue line) is below the actual Fed Funds rate (red line), indicating an excessively tight monetary policy.
 

 

As a consequence, the market is now expecting two rate cuts in 2024, with the first at the September FOMC meeting, followed by a second in December.
 

 

A higher bar

While the data is pointing to a rate cut in the near future, the political cycle is constraining the Fed’s actions in the short run. Ahead of the election in November, Powell needs a unanimous decision if the Fed is to cut rates in order to avoid the appearance of boosting in order to help Biden regain the White House. He can’t afford any dissents in a rate decision vote. As I pointed out before, there is a significant hawkish group of FOMC voting members (Bowman, Waller, Barkin, and Bostic) who are resisting rate cuts (see The Market Gods Present Patient Investors With Three Gifts).

 

The minutes of the June FOMC meeting reflect that divide within the FOMC. Fed officials “noted that the uncertainty associated with the economic outlook and with how long it would be appropriate to maintain a restrictive policy stance”. In particular, “some participants emphasized the need for patience in allowing the Committee’s restrictive policy stance to restrain aggregate demand and further moderate inflation pressures. Several participants observed that, were inflation to persist at an elevated level or to increase further, the target range for the federal funds rate might need to be raised.”Even though Fed officials have said that they don’t concern themselves with politics, the Fed intensely monitors market conditions, and the market is starting to discount the odds of a Trump win in November. Companies with domestic revenue are leading the S&P 500, which is an indication that the market is discounting higher tariffs in the future. The yield curve is steepening, inflationary expectations are rising, and gold has staged a triangle breakout, which is consistent with a Trump win (see Why the November Election Matters to Gold).
 

 

For what it’s worth, Goldman Sachs concluded that the effects of Trump’s proposed tariffs would boost short rates by 1.3%, or about five rate hikes.

 

 

The market should gain more clarity about the Fed’s likely interest path well before the September FOMC meeting. This Fed hates to surprise markets, and if a cut is likely at the September meeting, Fed speakers will begin a campaign to correct expectations of a cut just after the July 31 FOMC meeting. At a minimum, I would like to see greater transparency about its decision making framework after the July meeting.

 

New York Fed President John Williams said in a speech Friday that it’s not ready to cut just yet: “Inflation is now around 2-1/2 percent, so we have seen significant progress in bringing it down. But we still have a way to go to reach our 2 percent target on a sustained basis. We are committed to getting the job done.” If the Fed intends to signal that a September cut is not in the works, expect further messaging like this to continue.

 

 

Stay in your (narrower) lane

The short-term challenge for the Fed is its rate decision process. Here are the long-term challenges. Bloomberg reported that Powell is trying very hard to “stay in his lane” ahead of the November election:

“We’ve been given this great responsibility and great powers and it’s really important that we get it right,” he observed. “We’ve been told to ‘stay out of politics and do your job.’”
The problem, as all of them know, is that political decisions, from tariffs to energy policy, all have some impact on the economy.
 

The same goes for public finances. Powell restated that fiscal policy is a political matter, “so we don’t comment on it — and particularly in advance of a presidential election.” But he then acknowledged the challenges.
 

“You can’t run these kinds of deficits in good economic times for very long,” he said. “We’ll have to do something sooner or later, and sooner will be better than later.”

 

A little-known U.S. Supreme Court decision in finance circles may constrain monetary policy in the longer term. The Supreme Court reversed a long-standing precedent in the Chevron case, which limits the power of federal agencies to interpret ambiguous statutes. It was a resounding victory for conservatives in government deregulation. The NY Times described the implications of the decision this way:

The Supreme Court on Friday reduced the power of executive agencies by sweeping aside a longstanding legal precedent, endangering countless regulations and transferring power from the executive branch to Congress and the courts.
 

The precedent, Chevron v. Natural Resources Defense Council, one of the most cited in American law, requires courts to defer to agencies’ reasonable interpretations of ambiguous statutes. There have been 70 Supreme Court decisions relying on Chevron, along with 17,000 in the lower courts.
 

The decision is all but certain to prompt challenges to the actions of an array of federal agencies, including those regulating the environment, health care and consumer safety.

In the past, the Fed has used its “emergency authority” to buy assets, increase its balance sheet, and “abundant reserves” in response to the COVID Crash and the GFC. In light of the reversal of Chevron, the key question for the Fed is what Act of Congress allows the Fed to manage monetary policy like this?

 

The Fed’s has a dual mandate from Congress, namely “full employment” and “price stability”. Under the legal standard laid out by the previous Chevron decision, the Fed used “legal authority” granted by Congress to address “short-term liquidity needs”. Under the new Supreme Court’s interpretation of Chevron, does the Fed have that level of authority to interpret the law to define an “emergency”?

 

Imagine some time in the near future when the federal budget becomes increasingly constrained by fiscal dominance and net interest outlays exceed the primary deficit. One solution is a financial repression through yield curve control by the Fed by keeping long rates down through open market intervention. Will someone in the near future gain the legal standing to challenge the Fed’s decision-making authority under the new legal standard?
 

 

What happens in the next financial crisis? Supposing that a major financial earthquake occurs outside the U.S. In the past, the Fed would have opened up USD swap lines to maintain global financial stability. Will it have the same level of authority under the new standard? The Fed’s mandate is “full employment” and “price stability”. Financial stability is not part of its mandate. We have seen how the lack of a dual mandate affected the conduct of the European Central Bank, which has tended to err on the side of fighting inflation.

 

These are all valid questions. No one has the definitive answer at this point. What it does raise is a greater risk of global financial instability in the long run.

 

In conclusion, recent economic data is signaling a trend of growth deceleration, which raises the odds of a September rate cut. However, political considerations may derail a decision to ease in September as Powell may not achieve a unanimous vote, which would open the Fed to charges of interference in the electoral process. In addition, the Supreme Court’s recent repudiation of the Chevron decision opens the door to constraining future Fed policy to take extraordinary measures to stabilize the financial system in the event of a crisis.