The Fed has Trump's back. It may not be enough.

The economic expansion is getting fragile. Trump's tariff talk is messing with the economy.

The Fed can repair what Trump breaks. Or try to.

Fed Chair holds world in his hands

There appears to be no such thing as the "permanently high plateau" that was the famous description of the stock market level in 1929, just before it crashed.  

Recessions happen. 

Capitalism in its search for opportunities creates expansions, then contractions, as entrepreneurs respond to price signals that tell them there is money to be made, some of whom realize that it has already been made and that the opportunity is gone. Greed cycles with fear.

Events like trade wars can trigger an end to opportunity. Booms turn to busts. 

The investment world is full of short true-isms to guide investors trying to navigate the cycles: 

The big one: "Don't fight the Fed."

[Refresher: The Fed regulates financial markets by promulgating rules for banks, by regulating the money supply by buying and selling government bonds to banks and setting reserve requirements, and by creating currency. The Fed can set the rate at which they will buy and sell short term government bonds, and thereby influence all interest rates, including those for governments, businesses, and personal transactions.]

Federal Reserve Chairman Jerome Powell just sent a signal. He has Trump's back. The expansion is getting old, and Trump is making trouble. China tariffs are disrupting agricultural markets. Costco and Walmart announced that prices would be going up. Mexico tariffs would severely disrupt supply chains, especially the intertwined automobile one. 

The Fed announced it is "closely monitoring" the ecoomy and will "act as appropriate", i.e. lower rates again. That is how messages are sent. The future is uncertain and the Fed needs to maintain flexibility so they describe intention, based on concerns, not definitive plans. Bankers and investment managers interpret those signals. Their uncertainty over the signal makes buyers and sellers and therefore an orderly market.

The Fed is an archetypal example of one of the themes of this blog, that political actors communicate primarily through implication, not denotation. The Fed is not supposed to be a political actor, but it is, and this current Fed is unusually obvious about it. The Fed is supposed to be independent, and earlier Fed chairs maintained a fig leaf of it. Not this one.

The Fed reversing itself on interest rates is a big deal. They had been in a process of normalizing interest rates, which had been, by intention, set artificially very low in the aftermath of the financial meltdown of 2008-09. Low interest rates re-capitalized the banks--they borrowed money to re-lend virtually for free. Low rates made it very inexpensive for business people to crawl out of their fox holes and start taking new risks.

Low interest rates had some dangerous corollary effects. There was no yield for safe money. Pension funds--including ones like Public Employee Retirement System pools of money--need to have a significant portion of their money at low risk and volatility because if their pool of money fell too dramatically then actuarial professionals would say that the pool is badly underfunded--which they already are. Those investment pools target returns of about 7.2%, not zero.

Moreover, the general shift from defined benefit plans to 401-k type programs means that the risk of getting income out of a pool of money has been transferred to individuals, i.e. voters. They were unhappy. A retiree who had expected a 5% or 6% return on their money to pay bills, got zero instead.

Investment managers and the individuals had no choice but to take more risk than they wanted in the search for yield. That was, in fact, the Fed intention--to get people with money to take risks--but policy makers understood they had injected danger into the system. 

People were taking unwanted, possibly desperate risks seeking yield, buying junk bonds, speculating in real estate construction, buying stocks instead of holding cash. Misplaced investments are a classic cause of financial panics.

Click: April, 2019. Not so independent Fed

So in 2018 the Fed was returning investment returns back toward normal. Then Trump sent two signals of his own. One was publicly telling the Fed to lower interest rates, at least until after the 2020 election, and the more subtle one of nominating two people with minimal financial expertise to the Fed board who were openly supportive of Trump's political agenda. 

Message received. 

The Fed reversed itself and in December announced that they were not going to raise interest rates after all. The stock market, which had fallen almost exactly 20%, reversed itself immediately. 

That, too, sent a signal to the world. The Fed has power not just over interest rates but over the stock market.

The bad news for Trump is that the Fed is realizes that aggressive repairs may be necessary, which signals political people that Trump's strong economy may not last until election day. Dislocations are piling up, and it may be time for a contraction that voters will blame on Trump.

The Fed has Trump's back, but it may not matter. Recessions happen.