December 2018 — the month when the stock market decided to abandon all normalcy and descend into complete and utter chaos. The month which instilled fear in all Americans about whether or not the 10-years-aged bullish market had finally begun to falter. The month when the White House abandoned all of America and decided it couldn’t deal with this ever-so-volatile economy, and began to argue — of all things — about a wall.
Okay, okay, too dramatic — I know. Still, it’s not exactly wrong for me to say 2018 really did go out with a bang. During the month of December, the Dow Jones Industrial Average plummeted more than 15 percent before posting a 1,086.25 point gain on Dec. 26, 2018, “logging its biggest single-day point gain ever.” This surprising increase came a day after the S&P 500 drew within 2 points of entering a bear market — a condition wherein securities fall by 20 percent or more from a recent high.
Nevertheless, the market stayed resilient, refusing to drop into bear territory, and continuing said nearly 10-years-long bullish run — the longest such run in the market’s history. During this time, the unemployment rate hit historic lows, dropping below 4 percent. And amid such circumstances, the Federal Reserve was quick to raise the interest rates, especially as indices showed inflation rising above the 2 percent mark.
The White House was quick to criticize the Fed’s raised interest rates, with President Trump lashing out, claiming that “the only problem our economy has is the Fed.” Now, such an action is not exactly unprecedented, as past presidents have been known to bash the Fed over economic policy, but it does beg the question of whether or not the Fed is making the right decision.
Before we begin analyzing this, however, we must first understand the mechanics behind how the Fed manages economic growth. The Fed is in charge of maintaining the federal funds rate — the rate at which financial institutions, such as banks, borrow money from one another. This influences national interest rates, or, simply put, the price tag that a lender puts on the money loaned to a borrower.
When the Fed decreases the interest rates, the amount of investment also increases as people the cost of borrowing decreases. As such, the amount of loans demanded increases, thereby increasing the quantity of money (based on the fractional-reserve banking system). And when the quantity of money increases, so does inflation.
In this way, the Fed has the ability to adjust the economy’s level of inflation. But why does this matter? There exists a model in economics devised by economist William Phillips — appropriately named the Phillips Curve — that posits an inverse relationship between unemployment rate and inflation. While most economists believe some level of inflation is acceptable, they acknowledge that when it gets out of hand, inflation is detrimental to an economy. By and of itself, this must be managed so that it doesn’t get too out of hand. At the same time, however, if inflation is too low, the unemployment rate naturally increases. This dual mandate is inherently very tricky to work with, especially due to many caveats. Nevertheless, a balance must be reached.
The Fed’s move to raise interest rates in 2017 and early 2018 were very understandable. The United States had a booming economy that was showing no sign of stopping, something that is a signal of recession. However, as the inflation rate began to turn upwards of 2 percent following historic unemployment lows over the summer, in December it seemed to have stabilized around 2 percent, based on fourth quarter data. While it definitely is too early to declare the “war” with inflation has been won — especially given market volatility in 2018 — such a trend forecasts good things to come in 2019.
Nevertheless, the Fed still is on track for additional interest rate hikes in 2019, something I think should definitely be approached with caution. Amid all of Trump’s complaining on the Fed’s disruption of the U.S. economy this past calendar year, there actually might be some truth to it based on recent trends. It does appear that the economy has begun to cool down from the hot start it had in 2016. 2018 was “the worst year for stocks since 2008,” with the Dow and S&P both down by 5.6 and 6.2 percent respectively.
If the Fed were to overcompensate by increasing interest rates higher than they should be, the agency runs the risk of creating a recession by unnecessarily occluding economic growth. At the same time, if they undercompensate, the Fed runs the risk of inducing increased inflation. Both are formidably terrible outcomes in their own rights, but given our current circumstance, it seems to be a better idea to back the foot off the brakes a little and let the economy find its footing. This is perhaps strengthened by the fact that the global interest rates are running at levels much lower than those in the United States — a counteracting force out of the Fed’s control.
So despite Trump’s persistent complaints that the Fed is intentionally sabotaging his economy, it seems the Fed has truly been quite successful in managing the inflation rate thus far. Whether such a trend continues is determined by whether or not the Fed decides to back off on further interest rate hikes in 2019 (at least based on market signals today).
And Trump would do well to worry about his trade talks with China, which arguably played a large role in last year’s market volatility. Indeed, seeing to a resolution of some kind would help start 2019 off in a positive way.