Did the president introduce a “Trump Put” last week by lashing out about rising interest rates and calling for a weaker dollar? The market reacted swiftly and rationally — albeit not the way Mr. Trump had intended. Let me explain.
Mr. Trump suggested the United States is at a “disadvantage” given that the European Central Bank and Bank of Japan continue their more expansionary monetary policies. Markets reacted by selling off the dollar versus major currencies.
If that were all, you might shrug it off as the disruptor-in-chief rattling the currency markets a bit. Maybe there isn’t much more to it. After all, speculators had been bidding up the greenback of late, so possibly this was as good a catalyst as any to take some profits.
But that’s not the end of it. Mr. Trump says he favors a weaker dollar, so he may well provide more verbal intervention should the dollar resume its climb. In that sense, the president has indeed introduced a “Trump Put.”
But why is it that a comment by the president moves currency markets?
It may be partly because he has shown a willingness to use executive power to interfere with trade.
However, Mr. Trump went beyond suggesting the dollar should weaken. In an interview with CNBC that aired last Friday, he said, “I don’t like all of this work that we’re putting into the economy and then I see rates going up.” He then qualified his statement, saying, “But at the same time I’m letting them do what they feel is best.”
Yet, while Mr. Trump called for lower borrowing costs for the United States in an era of rising deficits, borrowing costs actually rose following his comments — the unintended consequence referenced above. In our assessment, it was no coincidence. Here’s why:
- The cheapest form of monetary policy is verbal. If a central banker tells us “rates will be low for an extended period of time,” the bond market will reflect this, assuming the comment is credible.
- If verbal guidance (think “forward guidance”) is insufficient, the central bank needs to raise or lower rates.
- In times of crises, lowering rates may be insufficient, and the central bank may need to intervene more heavily in the markets, such as through large-scale purchases of bonds (so-called quantitative easing).
As former Treasury Secretary Hank Paulson once said, if you have a bazooka, you may not need to use it. That is, to prove my point: words are “cheaper” than action.
Here’s the rub: When politicians start chiming in on monetary policy — especially if it’s someone influential who implies policymakers at the Fed could be fired (Trump is “letting them”) — it torpedoes monetary policy, diluting the Fed’s message.
As a direct consequence, it’s more expensive for the Fed to pursue whatever plan it has. In my view, that’s why bonds sold off and yields rose: debt that needs to be refinanced will be financed at a higher rate.
To be clear:
- Technically, Trump could fire Fed Chair Jerome Powell “for cause,” but I consider the odds remote.
- I don’t consider Mr. Powell to be a pushover.
Market professionals talk about an “increased risk premium” being priced into the yield curve. Differently said, the dollar just got “riskier,” explaining why yields rose, even as the dollar fell.
But if Powell is no pushover, does it matter what Trump says in an interview? Isn’t the Fed independent?
In my humble opinion, currencies — and monetary policy — are a credibility game. Monetary policy is effective because there’s a general belief the Fed will do the right thing. Anything that reduces this effectiveness is not desirable.
Note that the Fed shares responsibility for Trump’s comment. How come? Not because the Fed has raised rates several times and is expected to raise rates further, but because the Fed’s actions since the financial crisis have invited political interference as the Fed has stepped onto fiscal turf.
That is, the Fed’s buying of mortgage-backed securities is fiscal policy, as it allocates money to a specific sector of the economy. The Fed’s paying of interest on excess reserves is also a political hot potato, as the Fed is literally paying billions to banks in an effort to discourage banks from lending.
Not surprisingly, political attacks on the Fed have increased.
In the 1970s, political interference contributed to stagflation. In contrast, in the early 1980s, President Reagan had Fed Chair Volcker’s back when he raised rates rather substantially. Should we care about either of these precedents when the economy is doing reasonably well? The economy may be doing well right now, but consider the following scenario:
- The economy continues to grow at a reasonable pace.
- We are near full employment.
- Wage pressures continue to rise.
- The Fed continues to raise interest rates.
- The economy starts to slow down as higher rates start to have an impact on growth.
- Wage pressures continue to rise, even as the economy slows down.
- The Fed continues to raise interest rates.
Inflation is already at the Fed’s target of 2%. Some shrug off recent rises in inflation data as statistical aberrations, but an economic stimulus at a time when the economy runs near full employment may well make it plausible that my scenario is realistic.
Many pundits may scream “stop” once the yield curve inverts (when short-term rates exceed long-term rates), but keep in mind that the Fed’s mandate is not to prevent the yield curve from inverting.
Now put Mr. Trump into the mix. You have an economy that shows strains, yet the Fed continues to raise rates. In such a scenario, I would think it is perfectly plausible to hear more lashing out at the Fed from the president.
Will the Fed set different interest rates as a result? Even if Mr. Powell is no pushover, it may be costly nonetheless, as Fed policy may have gotten more expensive. That is, more action (higher rates) may be necessary because of the political interference than otherwise would be warranted. Again, there you have it: a “Trump Put” with unintended consequences.
Axel Merk is president and chief investment officer of Merk Investments.