Interest Rate Hikes Loom over the White House

The Fed chair will decide whether to begin an upward cycle of his key interest rate. His deliberation is arousing interest among Biden’s staff, as the outcome could have significant political implications.

Joe Biden’s choice to lead the Federal Reserve, announced Nov. 22, could be the most important nomination of his presidency and in terms of his legacy.

Biden offered Jerome Powell, first named to the post by Donald Trump in 2017, a second four-year term. Short of any unlikely surprise in the Senate, which must confirm the nomination, Powell will quickly face a fundamental decision: Should he raise the Fed’s key interest rate?

During testimony before the Senate on Dec. 1, Powell said what had already seemed evident to a good number of ordinary observers: The inflation of the last few months is, without a doubt, not “transitory,” and does not appear to be going away. To start with, the Fed must, in the short term, seek to slow its bond buying, a financial practice that injects billions of dollars into the economy. Just a few weeks into early 2020, the Fed more than doubled its total bond assets, which had already tripled over the previous decade.

This method of economic stimulus was appropriate after the first pandemic lockdowns, but with many economic sectors overheating, the Fed is now looking to take its foot off the gas.

The 2nd Issue

But the thorniest issue, and the one with the most consequences for Americans, is the interest rate. On this front, as well, the Fed agreed to a historic economic stimulus effort for modern times, and has kept its key interest rate near the bottom between 0% and 0.5% since March 2020. The average interest rate over the last 40 years has been more than 5%.

But the highest inflation in 40 years, as is the case now, should naturally lead to a rate hike, and therefore higher interest rates for consumers.

During the last period of sustained inflation at the end of the 1970s and the beginning of the 1980s, Paul Volcker, one of Powell’s predecessors, came to the rescue by pushing the Fed’s key interest rate from 5% to 14%. Mortgage rates topping 20% were commonplace.

That dizzying rise certainly contributed to the dreadful recession of 1981-1982, from which the U.S. nevertheless emerged stronger, with solid economic growth, low unemployment and inflation in check. Two years later in 1984, the incumbent president, Ronald Reagan, was reelected in one of the greatest electoral sweeps in American history, taking 49 of 50 states, mainly thanks to a speech during which he prided himself on having set the country back on its feet.

Powell will have a hard time playing savior for the current president like Volcker did 40 years ago, as there is nothing normal about the current situation.

Indeed, the unique nature of the current economic circumstances hinges on health restrictions, vaccination rules, even border control. The most recent employment numbers from Dec. 3 were markedly below expectations. This could curb the enthusiasm of those who favor a tighter monetary policy due to doubts on the true strength of the economy in such an environment.

It is, at least in part, for these reasons that the Bank of England is still resistant to raising its policy rate, to the surprise of many investors last month, surprise which is contributing to further hesitation this time around.

And then there is the elephant in the room: the national debt. If the national debt rose to a little less than $1 trillion in 1981, it has reached $30 trillion in 2021. In 1981, the debt-to-gross domestic product ratio was 30%; it has now reached 130%. Higher interest rates, of course, mean higher debt payments, so Powell has limited room for maneuver.

The election implications for Biden are rather considerable, as results of focus groups published by The New York Times after Powell’s testimony before the Senate have further shown. The economy, particularly the rise in consumer prices, remains the top concern for Americans.