Reprinted from Smirking Chimp
What happens if the Fed raises interest rates?
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Some of the folks watching the Republican presidential debates were struck by the fact that Donald Trump was apparently unfamiliar with the concept of the nuclear triad: that the United States maintains a nuclear force composed of land based missiles, submarine based missiles, and strategic bombers that can deliver nuclear weapons. This is the sort of basic knowledge of the U.S. military that someone hoping to be president should have.
In the same vein, there are aspects of economic policy that all the candidates should know. Unfortunately, when it comes to the Federal Reserve Board and its importance to the economy, most of the candidates seem to be failing as badly as Donald Trump did on his nuclear triad test.
The basic point is that the Fed has enormous power to control the pace of economic growth. It cannot always speed up growth as much as it might like, as we saw during the last recession, but it is quite capable of slowing the economy if it believes that it is growing too fast. It does this by raising interest rates.
Higher interest rates discourage people from buying houses or cars. It also discourages businesses from borrowing to finance new investment. State and local governments will also cutback borrowing for infrastructure and other long-term investments. And, households will not be able to reduce their debt burdens by refinancing their mortgages.
Higher interest rates will also raise the value of the dollar, making U.S. produced goods and services less competitive in the world economy. This will increase our trade deficit. Through these and other channels, when the Fed raises interest rates it slows the economy and the pace of job creation.
This is important in the context of the presidential campaign because we have a large number of candidates for both parties' nominations, who say they want to increase growth and create more jobs. The Republicans mostly plan to boost growth and create jobs with tax cuts, while the Democrats want to spend more on infrastructure, education, and research and development. But regardless of their route for boosting growth, or the coherence of their strategy, no candidate will be able to accomplish their goal unless the Fed is on board.
This is why the reaction, or lack thereof, to the Fed's rate hike was so striking. Vermont Senator Bernie Sanders was the only presidential candidate who went on record with a comment on the Fed's action, criticizing the Fed for slowing the economy and preventing people from getting jobs. This raises the obvious question of whether the other candidates understand the importance of the Fed to the economy.
Do the proponents of large tax cuts not realize that if the Fed jacks up interest rates in response to the deficits caused by their tax cuts, it will quickly cut off any boost to growth the tax cuts might otherwise cause? Do the advocates of infrastructure and education not realize that the jobs created by spending in these areas will be offset by jobs lost in other areas as a result of higher interest rates, if the Fed decides this is the appropriate course of action?
If the presidential candidates have not incorporated the Fed's reactions into their economic plans, then they really don't know what they are talking about. They will have no hope of boosting growth if they have a Fed determined to prevent the economy from creating more jobs.
The media should be asking the presidential candidates about their expectations from the Fed. Unfortunately any questions along these lines have been few and far between. Given the media's failure, the public at large will have to try to press the candidates on how they expect the Fed to respond to their economic program and how they might act to ensure that the Fed allows the growth they claim they will produce.
Any candidate who does not recognize the importance of the Fed, and have a clear path for dealing with its response to their proposed agenda, is as serious on economic issues as Donald Trump is on national security issues. Just like global warming, the Fed won't go away because some politicians choose to ignore it.