Why is the economy so weak? Trade gets headlines, but it’s more about past Fed rate hikes and the TCJA’s waste
The Federal Reserve meets this week against a backdrop of mounting evidence of a slowing economy. Since the last Federal Open Market Committee (FOMC) meeting, revised data on gross domestic product (the widest measure of the nation’s economic activity) and job growth have shown that 2018 saw much slower growth than previously reported.
Between April 2018 and March 2019, for example, the economy created 500,000 fewer jobs than had originally been reported. Only 105,000 jobs were created in August if temporary Census positions are excluded: this is roughly half the pace of growth that characterized pre-revision estimates of average job growth in 2018.
These clear signs of an economic slowdown raise the obvious question, “Why has growth faltered?”
While many pundits and economists have blamed the escalating trade conflict between the Trump administration and China, there are much more obvious sources of this slowdown: the Fed’s own premature interest rate increases between December 2015 and 2018 and the utter waste of fiscal resources that was the Tax Cuts and Jobs Act (TCJA) passed at the end of 2017.
To be clear, the Trump administration’s trade conflict is stupid and destructive, and its attempt to pin the blame for the slowdown on the Fed is self-serving. And the Trump administration’s scapegoating others for the weak economy takes real hubris given that its signature economic policy initiative—the TCJA—has been such an obvious failure in terms of spurring growth.
But the evidence is growing that the Fed did indeed raise interest rates too soon in the recovery and that this premature liftoff has begun dragging on growth. Worse, because raising rates slows growth more powerfully than lowering rates spurs growth, the Fed likely lacks the ability to offset this earlier mistake by pulling down rates going forward. The FOMC should certainly reduce rates at this week’s meeting, but it will need help from other policy levers—particularly effective fiscal stimulus—in the coming year.
Evidence of premature interest rate hikes
As Figure A below shows, after seven years of holding the effective federal funds rate at essentially zero, in December 2015 the Federal Reserve raised this rate by a quarter point. While many argued that a quarter-point increase in interest rates would not snuff out the ongoing recovery, I noted that raising rates while unemployment remained elevated and there was no sign of inflation made little economic sense. Worse, by increasing interest rates before any sign of inflation appeared in the data, the Fed clearly signaled that it was not eager to aggressively plumb just how low unemployment could be allowed to fall. This was a troubling signal: the Fed’s failure to aggressively target as low an unemployment rate as possible in recent decades has been a major reason why wage growth over this time has been so anemic. It took a year before the Fed followed up the December 2015 rate increase with another in December 2016, but in 2017 and 2018, it undertook seven quarter-point increases in the federal funds rate.
Interest rate ‘liftoff’ began in 2015, then picked up steam: Effective federal funds rate (FFR), 2000–2019
The data underlying the figure.
Source: “Effective Federal Funds Rate,” retrieved from the Federal Reserve Economic Data (FRED) database maintained by the Federal Reserve Bank of St. Louis, September 12, 2019
Given this short history of interest rates, it makes sense to look at the evidence on the effect of these rate hikes on growth. The most obvious place to look is at the performance of “interest-sensitive” components of gross domestic product since the rate hikes began in 2015. Generally, residential investment, business fixed investment, durable goods purchases, and net exports are thought to be the components of GDP that will be slowed by interest rate hikes.
Figure B charts how the average contribution of various components of GDP made to overall GDP growth changed between two time periods: the era of zero federal funds rates (from the second quarter of 2009 to the end of 2015) and the era of rising federal funds rates (from the first quarter of 2016 to the most recent quarter available, the second quarter of 2019). For three of these components (residential investment, business fixed investment, and net exports) their contributions to growth slowed notably as interest rates rose. For durable goods, the contribution to growth is roughly the same in both periods, but this is striking given that personal consumption expenditures besides durable goods saw a sharp upswing in the latter period. In short, there is ample evidence that rising interest rates have worked as expected in slowing interest-sensitive components of GDP growth.
Slowdown clear in interest-sensitive GDP components: Change to average contribution to GDP growth after interest rate liftoff, by component (percentage-point)
|Residential investment (housing)||-0.16|
|Business (nonresidential) fixed investment (NRFI)||-0.13|
|Consumer spending, excl durables||0.38|
The data underlying the figure.
Source and notes: Table 1.1.1 of the National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis (BEA). Average contributions to growth in gross domestic product (GDP) are calculated from 2009Q2 to 2015Q4, and then from 2016Q1 to 2019Q2. The bars represent how each component's average contribution to growth changed from the earlier to the later period. The GDP bar is shows the change in GDP growth from the first to second period. Durable goods, net exports, business investment (i.e., nonresidential fixed investment or NRFI), and residential investment (i.e., housing) are the most interest-rate-sensitive components of GDP.
To its credit, the Fed seems to have recognized that past rate hikes have dragged too much on growth and reduced rates at the last FOMC meeting in July. But research has shown that rate cuts spur growth less powerfully than equivalent rate increases restrain growth. This problem of “pushing on a string” was a prime argument made by those arguing that the Fed should err on the side of letting growth continue and letting unemployment continue to fall. If the economy continues to slow, the Fed will need help from fiscal policymakers to avert a recession; rate cuts by themselves are unlikely to do that job.
Very little sign of ‘trade war’ fingerprints on growth slowdown
The slight deceleration of net exports’ contribution to growth shown in Figure B may make some think there is a trade war–based explanation. There may be some influence of trade conflict on slowing growth, but this influence is likely pretty weak. For one, tariffs do not reliably reduce net exports—they instead reduce both exports and imports, with their effect on the trade balance (which is what matters for short-run growth) largely ambiguous. What is not ambiguous is the effect of a strengthening dollar on net exports—it reliably slows them. And since 2014, the dollar has risen sharply, driven strongly by developments in monetary policy in both the United States and its trading partners. It is important to realize that interest rate cuts made by the European Central Bank (ECB) late last week will put further upward pressure on the dollar going forward.
Some have noted that aside from the direct effect of tariffs, policy-induced uncertainty stemming from the Trump administration’s trade conflict might be holding back other components of growth, such as business fixed investment. Perhaps. But “uncertainty” is an awfully hard influence to define. And some of the only attempts to empirically measure this uncertainty actually show it is lower today than at many points in the last decade or more. Memories are short, but as recently as 2011 a Republican-led Congress seriously threatened to drive the federal government into totally unnecessary default on its debt if the Republican Party’s policy preferences were not signed into law by the Obama administration. This episode, it hardly needs to be said, created plenty of policy uncertainty.
The squandered opportunity of 2018’s TCJA
So if the recent economic slowdown is mostly not the fault of the Trump administration’s trade conflict, and it is mostly the fault of a too-hawkish Federal Reserve, does the president have a leg to stand on in scapegoating of Fed chair Jerome Powell? Not really. The reason why is simple: if President Trump had wanted faster growth, he should not have championed the waste of fiscal resources that was the TCJA, and instead should have used those resources to do things that actually would have created jobs and growth.
The TCJA is a debt-financed tax cut that will cost $150 billion annually over the next 10 years (before interest costs are added). Because the lion’s share of these tax cuts are accruing to rich households (mostly because the TCJA is primarily a corporate tax cut and owners of corporations are rich households), they have done very little to spur growth in aggregate demand (spending by households, businesses, and governments) in the short run. Rich households’ spending is not constrained by too-low disposable income, so boosting this disposable income largely does not lead to more spending. Poorer and moderate-income households, on the other hand, are indeed income-constrained in their current spending, so tax cuts or direct transfers to them would have boosted demand growth significantly. Direct spending—say on infrastructure or providing needed public investments like high-quality early child care—would have stimulated demand even more.
For a time, many credited the slight acceleration in growth in 2018 to fiscal stimulus generally. But revisions to 2018 data show this acceleration was even more subdued than previously thought. Further, the growth in government spending brought forth by a budget deal in 2018 actually provided much more stimulus than the more-expensive TCJA (see Figure B for this increase in government spending’s contribution to growth). The major component of GDP that has accelerated in recent years is consumption spending. Even if the entirety of the pickup in consumer spending shown in Figure B was attributed to the TCJA (and much of this pickup was surely driven by other factors, like tightening labor markets finally pushing up wage growth modestly), it would indicate that the TCJA was deeply inefficient as stimulus. TCJA proponents long argued that the main benefit stemming from it would not be short-run stimulus but a long-run increase in investment. This is awfully hard to see in the data—and as shown in Figure B investment (both business and residential) has been a prime source of weakness, not strength in recent years.
Essentially, President Trump and the Republican-led Congress largely squandered $150 billion in potential fiscal stimulus by prioritizing tax cuts for the rich over anything that would have plausibly created faster growth and jobs (see Table 1 in this report for a list of more and less effective fiscal policies to spur near-term growth). They are hence really the only economic observers in the world who have no standing to criticize the Fed for its clearly too-aggressive path of interest rate increases in recent years.
Despite bad-faith jawboning from President Trump, the Fed should cut rates
But just because President Trump calls for something—an interest rate cut in this case—doesn’t always mean it’s the wrong thing to do. The economy really is weakening, and this weakness has been led by sectors adversely affected by the Fed’s interest rate increases in recent years. Unfortunately, we could well find, a year from now, that rate cuts alone were not sufficient to avoid a recession—or even just a prolonged slowdown that pushes up unemployment. In that case, the Fed will need help from fiscal policymakers. But in the meantime, the Fed should take its role as the early-warning system on economic slowdowns seriously by cutting rates this week. This rate cut would provide a clear alert to other policymakers.