In 2017, a key monetary policy mistake of the US Federal Reserve under Janet Yellen was to keep monetary policy too loose despite a strong increase in US stock prices. Hopefully her successor, Jay Powell, does not make that mistake in reverse by keeping monetary policy unnecessarily tight despite a large fall in US equity prices.
If sustained, large stock market price movements have a material impact on economic growth. They do so through a so-called wealth effect, which changes how households feel about spending. When stock prices are high, households feel better about their finances and are more willing to spend. The reverse happens when stock prices decline.
The level of stock prices also influences the ease with which companies can borrow money to invest. When stock prices are high, companies find it much easier to borrow and invest than when prices are low.
This is especially relevant for monetary policy, considering how large recent stock price movements have been. In 2017, during US President Donald Trump’s first year in office, stock prices increased by 25%. This increased household wealth by around 30% of GDP. But since peaking in the first quarter of 2018, stock prices have fallen by 15%. That has erased 20% of GDP in household wealth.
According to Fed estimates, households tend to spend four cents of every dollar by which their wealth increases on a permanent basis. This implies that the strong 2017 stock market boom might have eventually added 1.25% to GDP growth. The current decline in stock prices could subtract around 0.75% from future GDP growth.
History will not judge kindly Yellen’s Fed for having allowed a stock market bubble to form and for having risked allowing the US economy to overheat. She did so by not moving towards a path of more aggressive interest rate increases as the stock market kept climbing. The Fed’s 2017 behaviour was all the more inexcusable considering that, in addition to being boosted by a buoyant stock market, the US economy was receiving a strong stimulus from a large unfunded tax cut, a weak dollar and a favourable international economic environment.
Powell’s Fed would seem to be dealing with a diametrically opposite situation to the one Yellen faced in 2017. Stock prices are falling while a strong dollar and synchronised weakening in the international economy are buffeting the US economy. The stimulus from Trump’s tax cut is likely to fade towards the end of 2019.
Against this backdrop, Powell’s change of tone on the need for further interest rate increases this year was encouraging. Hopefully, at the Fed’s scheduled meeting later this month, he will go further and suggest it is considering the case for an easing in monetary policy. He could do so by intimating not only a possible cut in the Fed’s policy rate sometime in 2019, but also by floating the possibility of a reduction in the current pace at which the Fed is shrinking its balance sheet.
Trump is complicating Powell’s task by attacking the Fed publicly for keeping interest rates too high. By so doing, he makes it difficult for the Fed to move to an easier monetary policy for fear of losing credibility in its independence. The greatest contribution that Trump could make to monetary policy implementation is to underline his full confidence in Powell and to leave it to the Fed to do the right thing.
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.