Why Trump Might Be Right About Interest Rates

What if President Donald Trump’s gut turns out to have been right and the Federal Reserve’s interest rate increases are holding back the U.S. economy?

There’s little evidence that the Fed’s rate increases are leading to slower economic growth. But there have been times in the past when higher borrowing costs damped the economy more than the Fed intended.

As markets have tumbled in recent weeks, analysts and economists are trying to understand whether that has happened again. And some believe the Fed has already applied the brakes strongly and should back off for a time.

“This is a good time to pause,” said Barry B. Bannister, head of institutional equity strategy at Stifel. “We are a lot tighter than people realize.”

How can that be when interest rates are still well below historical levels? It all depends on your starting point.

Bannister contended that the Fed’s main policy rate, the federal funds rate, was in effect significantly lower in the years after the 2008 financial crisis than the actual rate. As a result, the rate has gone up more than might first be apparent.

His case rests in part on a metric called the shadow fed funds rate. The measure was devised by two economists for the Federal Reserve Bank of Atlanta during the period when fed funds rate was kept close to zero. With that rate near zero, the central bank turned to bond purchases to stimulate the economy. But how to measure the effect?

The economists, Jing Cynthia Wu and Fan Dora Xia, used the yields on government bonds to calculate a shadow fed funds rate. Their intent was to estimate what that rate would have been if it could have fallen below zero.

In the years after the crisis, this shadow rate fell as low as minus 3 percent in May 2014.

Why does this matter today? The Fed has taken the fed funds rate at from zero in 2015 to 2.25 percent today. But using the shadow rate, the Fed has effectively taken that rate from minus 3 percent in mid-2014 up to 2.25 percent today, a much greater increase, and one that might now be pressuring the economy. The shadow rate stopped being calculated once the Fed began raising rates from near zero in December 2015 because it was less useful.

Recent big moves in stock and bond prices suggest investors are taking more seriously the possibility of a slowdown in the U.S. economy. Among their fears: The stimulus from the tax cuts enacted at the end of last year may be losing some of its oomph; other countries’ economies are not growing as fast as they were; the trade tensions may also have weighed on some economic activity.

Still, there are reasons to be skeptical of the argument that monetary policy is more stringent than it looks. A large effective tightening does not appear to be reflected in the economy or the markets. Gross domestic product is expected to grow a healthy 2.65 percent in the fourth quarter, according to economists surveyed by The Wall Street Journal. Bank loans grew at around 4 percent in the third quarter. And some assets have been sold off, but markets aren’t clamming up.

“Bond yields have risen a bit but are still pretty low, the dollar has appreciated only modestly and equities are just about flat for the year,” Eric Winograd, senior U.S. economist at Alliance Bernstein, said in an email, “all of which is consistent with only a modest tightening of financial conditions.”

If the U.S. economy does keep growing at a solid pace, and markets shake off the funk of the past few weeks, it will be clear that the Fed’s monetary policy was not too constricting. But the strong GDP numbers this year may turn out to be short-lived and the economy may now be adjusting back to the lower growth of the post-crisis years. If that’s the case, Trump, in his own way, may prove prescient.