Analysis

Trump's attacks on central bank rate hikes risk creating future economic trouble: Don Pittis

Critics say the Fed's Jerome Powell and Bank of Canada's Stephen Poloz risk creating a recession with rate hikes. But history shows rising rates do not kill booms — except when extreme action is needed.

Rate hikes cause recessions — but maybe only when they come too late

Stop raising interest rates, Trump has told Fed chair Jerome Powell. But letting the inflation genie out could be far more dangerous for the economy. (Carlos Barria/Reuters)

As markets have tumbled, U.S. President Donald Trump has been leading a charge against Federal Reserve chair Jerome Powell's interest rate increases, and he's not alone.

Investors watching markets slide have added their voices, worried that three rate hikes this year, one projected in December and another three next year will bring more carnage.

Bank of Canada governor Stephen Poloz faced similar criticism after last week's quarter-point hike to 1.75 per cent.

But while skittish markets — during a month when markets are often skittish — have focused on small rises in interest rates as the death knell for the current economic revival, there are good reasons to think the worries of traders are baseless.

Hike happy 

As told by Trump, who fears that rising interest rates will wreck the stock market boom he has claimed as his own, the argument is pretty simple.

"Every time we do something great, he raises the interest rates," Trump told the Wall Street Journal in an interview last week. The "he" in that quote is Powell, who Trump said "almost looks like he's happy raising interest rates."

Anyone who watches his public appearances knows the serious-minded Powell never looks especially happy. But, oddly, with a doctorate from Princeton and experience at the highest level of investment banking, Powell has seemed unconcerned that interest rate increases will somehow send the economy into a tailspin.

When he met with reporters after the Fed's latest rate rise, he expressed confidence that the economy was going through one of its best times.

In the complex world of finance, no one knows the future, but one question market traders might want to ask themselves is, when it comes to economics and the state of the markets, should they trust the president or the Fed chair?

You don't have to go too deep into the complexity of real-world economics to show that some sort of one-to-one relationship of creeping hikes in interest rates leading directly to a crashing economy and tumbling stock market is just not what happens.

Blaming the punch bowl

And maybe part of the blame should be directed at William McChesney Martin, the longest-ever serving head of the U.S. Federal Reserve, who created the famous punch bowl analogy.

The central banker, said Martin in a 1955 speech to a group of investment bankers, "is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up."

Fear of the proverbial punch bowl being taken away may have accentuated October market jitters, but rate hike worries could well be overblown. (Everett Collection/Shutterstock)

So the question is: Do gradually rising interest rates really slam the brakes on a thriving economy, as this conventional reading of the punch bowl analogy insists?

According to a paper by longtime monetary policy expert Philip Turner, formerly at the Bank of International Settlement — the so-called central bank's central bank — the relationship, if it exists, is not obvious. He points to the fact that interest hikes before the crisis of 2007-08 did little to rein in market excesses.  

"The substantial increase in the Federal funds rate from mid-2004, reinforced by higher policy rates elsewhere, did not prevent further increases in risk-taking in the financial markets during this period," Turner wrote in a 2017 paper titled "Did central banks cause the last financial crisis? Will they cause the next?" 

A recent interview in the New York Times with Paul Volcker, the Federal Reserve chair who really did bring the economy down with high interest rates, was also a reminder that those times were completely unlike today.

Volcker's scourge

When Volcker took office in 1979, the rate of inflation was already soaring in the wake of the first oil crisis and by 1980 had risen to 15 per cent. The savings of older people living on fixed incomes were melting away.

"Volcker comes in and he says, 'Hey, guys, this is bad, this is very costly for the economy,'" says Christopher Ragan, currently in the headlines as head of the pro-carbon tax Ecofiscal Commission, but actually a specialist in monetary policy at McGill University. 

He says Volcker was forced to take extreme action, raising the Fed rate to a peak of 20 per cent, pushing commercial lending and mortgage rates to much higher than that. The economy was smashed. Unemployment soared. Businesses went broke. Farmers protested.

"You basically create a recession and you wring inflation expectations out of the system," says Ragan. It's not that central banks cause recessions, he says, it's that central banks are forced to create recessions when people begin to expect high and sustained inflation.

If banks followed Trump's advice and left the impression inflation could rise and rise — "Five begets six begets seven which begets eight," Ragan quotes one central banker as saying — then eventually they could be forced to follow the Volcker strategy.

But that is not what is happening now. Instead, inflation expectations remain at about 2 per cent, and central bankers have no need to hike interest rates enough to create a recession, just enough to convince everyone that they will not let inflation climb out of the 2 per cent range.

"Every time inflation shows a tendency to rise, you raise interest rates a little bit," says Ragan. "And people say, 'Oh! The central bank really means it.'"

Ragan says there is no reason homeowners or market traders should be terrified that small rate increases will damage a strong economy.

"We are raising rates because the economy is sturdy and strong."

Follow Don on Twitter @don_pittis

About the Author

Don Pittis

Business columnist

Don Pittis was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London. He is currently senior producer at CBC's business unit.