The Fed and monetary policy is making news once again with questions to which money managers are anxiously awaiting: “Will the Fed reduce interest rates, and by how much?”

There is nothing new about Wall Street hanging on every word uttered by members of the Fed’s Board of Governors, or that they pay more attention to short term interest rates than to performance of the economy. What is news about the current scene is the assumption that the Fed will lower rates — some speculate that it may be by 50 basis points instead of 25 — during a period of low unemployment and financial markets flirting with record highs.

President Trump has been hammering on Fed Chair Jerome Powell to reduce interest rates. Powell has painted himself into a corner with language about the Fed seeing potential softness in the economy. This is construed by Wall Street as assurance of a reduction of interest rates and has resulted in a mid-July bounce in financial markets. If the Fed reduces rates, it will have been expected, is no doubt already priced into financial markets. 

By reducing interest rates during full employment, the Fed is reducing tools in its arsenal that would better be reserved until urgently needed. And Powell will be accused of having been brow-beaten by Trump, just another toady to an autocratic president.

But if the Fed doesn’t come through with the expected rate reduction and this is followed by disappointment and tanking financial markets, guess who will be blamed. By loosely teasing about a rate reduction during full employment and strong financial markets, Powell is in a trap of his own making. 

Let’s put the role of monetary policy in perspective.

There are many factors that determine the economic strength of a nation. These include its natural resource base. This is significant, but among the least important compared to other factors. If the natural resource base were the most important, Switzerland would be Europe’s poorest nation, as it once was.

A nation’s human capital refers to the collective knowledge, skills and work ethic of its people. A nation’s stock of scientific and technical knowledge is an invaluable asset that can be used to further enhance a nation’s productivity, including building physical capital for the benefit of the nation.

So yes, a nation’s natural resource base, its human capital, and its collective stock of knowledge are important. But there is yet another factor that distinguishes a productive economy and stable society from a languishing economy and an unstable society. That crucial factor is its institutions, broadly defined.

The organization and functioning of its economy and its government, its system of laws, its system of incentives, its distribution of the fruits of production, and its assumption of responsibilities by business and citizens are the differentiating factors between a functioning nation and a struggling one.

For example, no rational person can doubt the work ethic of Mexican nationals. And Mexico is rich in natural resources. The difference between the US and Mexico is their institutions.

In other words, it’s “the system.” “The system” depends on an intelligent, rational interaction of government and business that will necessarily include some tensions — regulations that protect health, environment, and rights of workers having less market power than their employers. Institutions include scientific, educational, and medical institutions that interact with various units and levels of government. 

Strength and viability of our institutions, including adherence to laws and unwritten norms, is vitally important. Our distribution of income, resulting in increasing disparity between our wealthiest citizens and everyone else is a source of instability that threatens and undermines faith in our institutions 

While our system of elementary education serves students of affluent districts well, there is increasing disparity of education between affluent and poor districts, that disparity becoming more alarming as it further induces destabilizing income disparity.

In this rapidly changing society, there is a staggering list of structural economic problems that need intensive effort. This requires a functioning government with the objective of making capitalism work for all people for the ultimate benefit of a growing economy and a stable society.

For any long term structural reforms to have a ghost of a chance to occur, we need at the minimum, a fully employed economy with stable prices that ideally rise at approximately a two percent rate. This is where the role of government to achieve these objectives comes in. Fiscal policy and monetary policy are the two major tools of the Federal government with which to achieve full employment and stable prices.

Fiscal policy, government spending and taxing with the objective of economic stabilization, is the stronger of these two major tools. But rational fiscal policy, intended to be implemented by the president and the congress, has long been abandoned. This leaves monetary policy that is not equipped to address long term structural problems, and only weak tools with which to address employment and price levels.

With the economy steadily improving since the Great Recession, the Fed has gradually increased interest rates — as well they should have. While Trump complained that previous Fed Chair, Janet Yellen, had not raised interest rates fast enough, he now beats on current Fed Chair Powell to reduce interest rates.

This brings us to the trap that Powell has set for himself, indicating a likely reduction in rates even as Trump insists that the economy is the best ever. While there are signs of a softening economy, many critics, including this scribe, insist that there should be no reduction at this time. And talk of a 50 basis point reduction is just plain insanity when we have such low unemployment and near record financial markets.

Apologists for a rate reduction assert that it would be “an insurance policy” to insure prosperity. A more valid “insurance policy” would be to not reduce rates at this time, keeping a potential reduction in reserve for when it will urgently be needed.

— John Waelti of Monroe, a retired professor of economics, can be reached at jjwaelti1@tds.net. His column appears Saturdays in the Monroe Times.