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Is Donald Trump's Criticism of the Federal Reserve Justified?

Image source: Donald J. Trump for President.

Donald Trump accused the Federal Reserve this week of playing politics by keeping interest rates low to spur the economy and improve the odds that Hillary Clinton will win, given her connections with the Obama administration. This scenario has happened in the past, when Richard Nixon was president, but there's little evidence to suggest it's happening now.

Trump's salvos mark a change in his stance on the Fed, and specifically its chairwoman, Janet Yellen. Four months ago, the Republican presidential candidate told The Wall Street Journal that he had "great respect" for Yellen. But in an interview with CNBC on Monday he reversed course, saying that she "should be ashamed of herself."

"She's obviously political and doing what Obama wants her to do," Trump said. "What they [the Fed] are doing is, I believe, it's a false market. Money is essentially free."

Is Trump right about the Federal Reserve?

Trump is right that money is essentially free right now. The key interest rate benchmark that the Fed uses to set monetary policy, the Fed Funds rate, has been hovering near 0% since the central bank slashed it in the wake of the 2008 financial crisis. This is unprecedented, both because rates are so low and because they've stayed so low for so long.

It's also clear that a healthy economy helps the incumbent party. "Run for reelection during a bad recession, as Jimmy Carter did, and you'll likely lose," The Week's Ryan Cooper wrote last month. "Run during a boom, as Ronald Reagan did, and you'll likely win." Lest you have any doubt, just ask George H.W. Bush, who many believe lost his 1992 re-election bid because the Fed didn't reduce rates enough to combat the post-Gulf War recession.

But to claim that the Fed's current monetary policy is motivated by political concerns, doesn't comport with reality. After all, the Fed isn't the only central bank in the world that's keeping rates low -- every other major central bank is doing the same thing. Those in Europe and Japan have gone so far as to adopt negative interest rates, a step beyond the ultra-low rates in the United States.

Not to mention that the Fed has in fact begun to raise rates. It took its first swipe last December, when it boosted the target Fed Funds rate by 0.25%. It's since held off from further rate increases, as slowing economic growth in China, concerns about Britain's pending exit from the European Union, and low energy prices have fueled uncertainty in global financial markets and encouraged the central bank to adopt a more cautious strategy.

The Fed has nevertheless made it clear that it wants to continue raising rates and is on the verge of doing so. Last week, Fed Governor Eric Rosengren intimated that interest rate hikes will be on the table at the central bank's meeting this month. And on Monday of this week, his colleague Dennis Lockhart followed suit, saying that "circumstances call for a lively discussion" about a rate rise at the upcoming meeting.

This is peculiar behavior if the Fed is trying to sway the election through monetary policy, as even the slightest hint that it will raise rates tends to send asset prices tumbling. We saw this last Friday, when Rosengren's comments triggered a broad sell-off in the stock market, causing the Dow Jones Industrial Average to fall nearly 400 points.

Why the Fed is keeping rates low

To be clear, there are arguments in favor of raising rates. The CEO of a major U.S. bank told me earlier this year that he thinks a rate rise may even spur economic activity. It will encourage businesses to rush out and borrow money before it's no longer essentially free, he explained, which would boost business investment.

Returning to more normalized rates would also be good for general sentiment, says JPMorgan Chase Chairman and CEO Jamie Dimon. Here's what he said on Monday:

Let's just raise rates. The Fed has to maintain credibility. I think it's time to raise rates. Normality is a good thing, not a bad thing. The return to normal is a good thing.

But for ever argument in favor of higher rates, there are two in favor of proceeding cautiously. The Great Depression offers insight into the perils of doing so prematurely, before the economy can stand on its own two feet. The Fed's decision to boost rates in 1937 is widely believed to have caused the economy to halt its recovery and descend again into depression. It was a costly mistake that Yellen and other members of the central bank's Board of Governors have no interest in repeating.

The strong dollar is almost certainly another reason that the Fed is taking a slow and steady approach to increasing interest rates. The U.S. dollar has climbed consistently over the past few years relative to the currencies of our major trading partners, including Japan, Europe, and Mexico. This makes U.S. exports more expensive and thus less competitive abroad. And things would only get worse under higher rates, attracting an inflow of capital into the United States (this boosts demand for the dollar and thereby increases its price in other currencies -- i.e., its exchange rate).

But the most important reason of all for the Fed's decision to keep interest rates low is because inflation has stayed below the central bank's 2% target, which falls under its dual mandate to balance price stability against full employment. Consumer prices in July, the latest inflation data, rose only 1.6%. This is problematic, as Fed Governor Lockhart noted Monday morning at the 58th National Association for Business Economics Annual Meeting in Atlanta:

[I]nflation has been very constant for four years now. It's been consistently around 1.6% and has varied from that reading by only two-tenths or less. By this measure, progress toward the Committee's inflation objective appears to have stalled. The inflation data overall have not been suggesting disinflation or deflation, but the flat trend line is enough below target that, in my opinion, the shortfall cannot be considered immaterial. I find this to be an awkward state of affairs.

The point here is that the Fed has bigger fish to fry right now than the presidential election. Its job is to continue supporting the economy through its recovery from the worst financial crisis since the Great Depression, the latter of which, as I explained, was prolonged by the Fed's decision in 1937 to prematurely raise rates. Trump may not know this history, but you can rest assured that Yellen does.

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John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.