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Did Dudley Do Right?

The New York Federal Reserve's immediate past president recently caused controversy by calling on the Fed to make it “abundantly clear" that President Donald Trump will bear "the consequences" of his fiscal and trade policies. But what does "abundantly clear" entail?

HANALEI, HAWAII – William Dudley, the immediate past president of the Federal Reserve Bank of New York, recently stirred up a hornet’s nest when he called for the Fed to consider the impact of its policies on the 2020 presidential election. In fact, Dudley performed a valuable public service by observing that Fed policy can influence politics, sometimes with profound implications for the course of the United States. But that doesn’t mean his recommendations were on target.

Dudley’s logic was straightforward. If the Fed cuts interest rates in response to Donald Trump’s disruptive trade-policy actions, the president may be encouraged to resort to more of the same. Trump believes that the US and China are locked in a trade war to the death. But he also has acknowledged that the stock market reacts negatively to his tariff threats, that trade-related uncertainty weakens growth, and that this damages his reelection prospects.

The worry is that if the Fed loosens policy, thereby minimizing an uncertainty-induced slowdown in investment and growth, Trump will feel free to escalate his China-focused trade attacks. As Dudley put it, the Fed should make “abundantly clear that Trump will own the consequences of his actions.”

The question is what exactly making it “abundantly clear” entails. Federal Reserve officials can explain that the president’s actions are forcing them to lower interest rates in order to fulfill their dual mandate of stable inflation and maximum employment. They can warn of the collateral damage of low interest rates, which harm Americans living on fixed incomes and raise financial stability risks by encouraging investors to stretch for yield. The Fed should flag these undesirable consequences without hesitation.

Fed officials should also emphasize that monetary loosening cannot fully neutralize the effects of trade-policy uncertainty. Many investments, once undertaken, are reversible only with difficulty, to the extent that they’re reversible at all. Investments predicated on the existence of global supply chains will be rendered worthless by a full-blown trade war. Equally, investments in local production, predicated on ongoing trade conflict, can turn out to be costly mistakes if commercial peace unexpectedly breaks out.

When trade policy is uncertain, miscalculations like these are unavoidable. Companies therefore have an incentive to delay investing until that uncertainty is resolved – whatever the level of interest rates. The central bank needs to remind Trump that it can’t entirely offset the macroeconomic impact of his trade war, no matter how much he wishes this to be so.

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Dudley’s most provocative remark was that “there’s even an argument that the election itself falls within the Fed’s purview.” Seeming to suggest that the Fed should seek to influence electoral outcomes, this comment ignited ferocious criticism, and Dudley subsequently walked it back. Fed officials “should never be motivated by political considerations or deliberately set monetary policy with the goal of influencing an election,” he clarified.

But Fed policies do influence elections, and this indisputable fact has consequences for the central bank. Policy-rate reductions that head off an impending recession make Trump’s reelection more likely. In turn, his reelection implies slower growth in the medium term, insofar as it means continued erratic policies, commercial conflict, and uncertainty. How should a Federal Reserve, whose mandate extends to ensuring “maximum employment,” trade off short-term employment gains against longer-term employment losses?

This is a difficult question, not least because the Humphrey-Hawkins Act, which gives the Fed its mandate, specifies no timeframe for achieving it or a discount rate at which current gains can be weighed against future losses. But that conversation is unavoidable. Or at least it should be.

Much of this discussion can take place in private. But imagine now that the Democrats nominate a 2020 candidate with very different trade-policy predilections. Fed staff and governors will then have to formulate economic forecasts that describe two different paths for the economy depending on the outcome of the election. The Fed, as an agency accountable to the Congress, will face pressure to make these forecasts public. One can well imagine the resulting tweetstorm of opprobrium accusing the central bank of partisanship and worse.

Should the Fed suppress or fudge its forecasts in order to appear apolitical? Doing so would be a dereliction of duty, which is to forecast economic scenarios and formulate policy accordingly.

The Bank of England faced an analogous dilemma when opining on the implications of Brexit for the British economy, and it was subjected to withering political attacks. Political flak and discomfort are part of the job description – and unavoidable when making public forecasts under such circumstances. Politicians will impugn central bankers’ impartiality. Unavoidably, controversy and reputational damage will follow.

In speaking out, Dudley conveyed another important message: the brickbats are worth bearing. Were the Fed to pull its punches about the obvious risks US fiscal and trade policies now pose to the US economy, the reputational damage it would suffer would be infinitely worse.;
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