Interest rates respond to Trump tax cuts ~ Middle Class Alert!

Middle Class will be negatively impacted!

The Federal Reserve raised interest rates again! It’s said that President Trump isn’t all that happy about it. 

Well, that’s what an independent central bank does for you — it removes monetary policy from politics. There is a certain amusement here, though, which is that the Fed has raised rates not to annoy Trump, but because of Trump.

We have two sets of tools by which we can direct the economy in general, two types of macroeconomic policy. There is fiscal policy, which is taxes and spending, the balance between them. There's also monetary policy, interest rates and a number of more minor associated matters. Either or both can be used to direct that economy as whole. No, this isn’t the start to a beginner’s economics textbook, just take that as being true. It’s the basic outline of absolutely every model that any government, central bank or part of academia uses. It is true in this world even if it’s not in theory.

The thing is though, according to a theory currently best associated with the economist Scott Sumner, in a world with an independent central bank, we don’t actually have that fiscal policy that we can use. For the bank, as the Fed has done here, will simply alter monetary policy in order to take account of whatever is being done with fiscal policy. We might, for example, say we’re in a recession and slash taxes, or increase spending — those Keynesian sorts of things recommended back in the Great Recession — and this will boost the economy. 

But whatever interest rates would have been in the absence of that policy, or possibly the amount of QE and those associated minor matters, will be changed in order to reflect that new fiscal policy. Or maybe we think we’re in a boom and so we increase taxes to slow it down — again, Keynesian policy — but then the Fed will set interest rates lower than they would have done in the absence of the tax rises.

Fiscal policy doesn’t work in a world with an independent central bank, for that bank will always offset those macroeconomic effects of things like the budget deficit. The policy mixture will always end up being what the bank thinks it ought to be, for they’re the balancing item here.

Thus it isn’t that Jerome Powell is doing his job by ignoring Trump. Maybe Trump isn’t happy about that rate increase. Sure, it’s the third one this year. But Trump isn’t being ignored, the Fed is reacting to what Trump has done.

There was a package of tax cuts, which also hasn’t cut spending much, if at all. Thus, the deficit is blowing out. Our standard Keynesian model — recall, it doesn’t really matter if it’s right or not, given that all policy makers assume it is, that’s how they’re going to react — tells us that this will stimulate the economy. 

But then so also can monetary policy stimulate or slow down that economy. So, when fiscal policy is stimulating, monetary policy will be adjusted to be a bit more calming. The overall policy mix doesn’t, therefore, change.

My personal opinion is that Sumner is a tad over-reaching when he says that the two policies will always balance perfectly — I tend to not believe that any macroeconomic policy is that accurately calculated. But the underlying point is still true.

However much the Fed is annoying Trump by raising interest rates, they’re still doing it because of him. Trump’s tax policies have been a stimulus to the economy, therefore they’re raising interest rates faster than they would have done in the absence of that fiscal policy.

Tim Worstall (@worstall) is a contributor to the Washington Examiner's Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute.