After just a few days, Jay Powell, the newly appointed chair of the US Federal Reserve, has had a career-forming week. The bond and stock markets are informing him of the monumental monetary policy problems that lie ahead.
The spike in US long-term interest rates is alerting Powell to the inflation risk that might result from an overheated US economy. The volatility in stock markets seems to highlight the possibility that too rapid an increase in interest rates could lead to the disorderly bursting of the global asset bubble. That, in turn, could bring on another US and global recession.
Powell may wish to blame his predecessor for the policy predicament in which he finds himself, although he has been a member of the Fed’s board of governors since May 2012. Last year there were clear signs that the global economic party was getting out of hand, but Janet Yellen allowed equity and bond market bubbles to inflate further.
The Fed has been slow to raise interest rates. Yellen did not revise the Fed’s path to increasing interest rates despite the strong boost a US economy close to full employment was receiving from the combination of buoyant equity prices, a depreciated dollar and an unfunded tax cut.
Powell’s first order of business will probably be to calm jittery markets by exuding a strong sense of confidence and control. If markets continue to swoon, he might wish to follow the example of a newly appointed Alan Greenspan. The Fed chair responded to Black Monday in October 1987 by issuing a one-sentence statement reassuring markets of the Fed’s readiness to serve as a source of liquidity to support the economic and financial system.
Powell’s next major policy decision will come on 20-21 March. His appropriate course of action at that Fed meeting is far from clear, being highly dependent on what happens in the markets in the six forthcoming weeks.
Should global equity markets regain their footing, Powell would be well advised to raise interest rates as planned and make it clear that the Fed remains committed to its inflation target.
However, should markets continue their downward movement and asset bubbles start to burst, the last thing Powell should do is raise interest rates. At a time when the US economy might be heading for another recession, Powell might need to worry about the renewed onset of deflation.
The mistake made by the Bernanke and Yellen Feds was to rely excessively on aggressive quantitative easing to get an economic recovery going. While this produced a recovery, it did so at the long-run cost of distorting asset prices, thereby setting the stage for the next bust.
In the event of a bust, Powell should make every effort to educate Congress and the administration about the risks of once again relying too heavily on monetary policy to revive the economy. Instead, he should push strongly for some variant of Milton Friedman’s ‘helicopter money’ that would involve the Fed financing the Treasury on the easiest of terms to send a cheque to every citizen.
Only then will the Fed succeed in generating an economic recovery without distorting financial market prices.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.