Tuesday, August 13, 2019

President Trump: the Fed's Biggest Moral Hazard

Perhaps the Federal Reserve's biggest problem today is that it has a moral hazard problem with President Trump.  A moral hazard is a situation in which a person can take risks without having to bear the full consequences of those risks.  For example, when stock market investors think the Federal Reserve will cut interest rates to prop up the economy and the stock market should things go downward, they are more willing to buy stocks because they expect a bailout from the Fed.  This can lead to over-investment in stocks and greater potential for an asset bubble that can later burst painfully.

President Trump's trade war with China has created uncertainty.  The economy is slowing and the stock market has been trending downward for several weeks.  Trump has been haranguing the Fed to cut interest rates, evidently in the belief that such cuts can offset the negative impact of his trade war.  There is considerable debate among economists and others whether the Fed can actually prop up the economy and stocks while the President exchanges volleys of tariffs and other trade restrictions with China.  Perhaps the Fed can soften the impact, but it seems doubtful the Fed can do more than slow down the negative impacts of the trade war.  When the Fed lowers rates in what is already a low-rate environment, that signals things are going to be bad.  Businesses pull back, slowing hiring and investment.  Consumers spend less..  The rate cuts could produce a self-fulfilling prophecy.

However, as long as President Trump believes the Fed can offset the damage his trade war does, he has no incentive to act prudently.  He may instead proceed recklessly and then turn to the Fed to put out the fires he starts.  This is an extremely concerning instance of moral hazard, and one for which there is no easy solution (because the President doesn't seem to understand economic reality).  The President could trigger an economic downturn and a bear market with no certainty that he could secure a good trade deal.  And we'd all pay the price.