On the day Jerome Powell succeeded Janet Yellen as Federal Reserve Chairman, the Dow fell more than a thousand points, its largest point drop in history. In the past week, Powell spoke for the first time on on Capitol Hill, twice. Neither day was a good day for stocks.
Although the day-to-day movements of financial markets are hardly a reflection of the current state of the economy, its excessive volatility is indicative of the heightened uncertainty surrounding economic policy in 2018, and beyond. As the economy reaches its ninth year of economic expansion, stiff headwinds emerging on the horizon will present new challenges for Powell and the Federal Reserve.
In his Senate testimony, Powell acknowledged the job gains, lower unemployment, and sustained economic growth that has occurred under the stewardship of his processor, Janet Yellen. It was Yellen who began normalizing monetary policy following the historic quantitative easing of the Ben Bernanke era, and many in Congress were understandably concerned about the pace of interest rate hikes over the coming year. Indeed, Powell unexpectedly took a more hawkish tone and suggested that there could be as many as four hikes this year, saying “the things we don’t want to have happen is to get behind the curve, have inflation move up and have to raise rates too quickly and cause a recession.”
Higher inflation is imminent
If the recent economic indicators are right, signs are that higher inflation is imminent:
1. The one-half percentage point increase in the CPI for the month of January was greater than expected and broad-based. Even removing the more volatile components of food and energy, core CPI increased at an annual pace of 3.6 percent, well beyond the Fed’s long term target of 2 percent.
2. A tightening labor market is placing upward pressure on nominal wage growth. The 2.6 percent jump in the Employment Cost Index in 2017 is the highest annual increase in almost 10 years. Firms will pass these additional labor costs to consumers in the form of higher prices.
3. The Republican tax bill passed by Congress in December will exacerbate inflation concerns. The large corporate tax cuts represents a $1.5 trillion fiscal stimulus and comes at a time when the economy is very near or at full employment. Such fiscal stimulus will elevate long term interest rates, separate from monetary policy action, and the higher cost of borrowing for businesses can easily negate any incentives for additional investment.
In his prepared statement before the Senate, Powell acknowledged that “fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation … will move up this year.”
So while the growth effects of the tax cuts are questionable, pouring gasoline on a fire will most certainly trigger additional inflationary pressures.
Powell can’t cave to Trump on rates
On top of the economic challenges facing the Fed, the charged and polarized political climate in Washington will make Powell’s job even more difficult. There will be enormous pressure for the Federal Open Market Committee to keep interest rates low and scale back the reduction of its enormous balance sheet. Uncertainty about inflation and the aggressiveness of monetary policy has already triggered volatility in financial markets and may foretell of what’s to come.
The Trump administration has often used the stock market as a gauge of economic success and market crashes of more than 1,000 points do not present a good political narrative. President Trump, who does not recognize the traditional boundaries of our government institutions, will no doubt expect loyalty from his appointed Fed Chair. He has previously expressed fondness for a low interest rate policy and will no doubt make that clear to Powell should the stock market retreat from last year’s record pace.
Powell himself seemed to recognize this political challenge and during remarks on Capitol Hill reassured that market volatility does not “weigh heavily” on his outlook for the economy. However, the Fed Chair also flip-flopped over the course of the two hearings, later retreating from his hawkish sentiments and saying, “nothing is suggesting to me that wage inflation is at a point of accelerating.” He added, “strengthening in the labor market can take place without causing inflation.”
It is this inconsistency that can lead to a credibility issue for the Fed. Unfortunately, we have seen this play out before. In the 1970s, Richard Nixon placed undue pressure on then Fed Chair Arthur Burns to pursue an expansionary monetary policy in an effort to bring the unemployment rate down and secure his reelection. The outcome was nearly a decade of double-digit inflation with high interest rates and high unemployment.
This presents a dangerous scenario for the economy, especially in the deregulatory environment of the current administration. Powell, a lawyer who comes from the world of investment banking, has echoed President Trump’s desire to ease or remove financial regulations put in place in the aftermath of the financial crisis. Doing so while keeping interest rates low is what caused the excessive risk taking by large banks and financial collapse. Before her departure, Janet Yellen warned of the consequences of forgetting the lessons of the financial crisis that led to the Great Recession.
Navigating the perils of the economic and political headwinds will require strong leadership from Powell and an independent Federal Reserve. Although Powell’s appointment is seen as offering continuity to the policies of Janet Yellen, he will be the first non-economist at the helm of the most important economic policymaking institution in nearly forty years. As such, he must leverage the expertise of the professional economists on the FOMC and ground his decisions on sound economic principles to achieve the objectives of sustained economic growth and low inflation consistent with the Fed’s mandates.
—By Victor Li, associate professor of economics at the Villanova School of Business. Li previously worked with former Fed Chairman Ben Bernanke at Princeton University, and also worked as a visiting scholar at the Federal Reserve Bank of St. Louis, and a senior economist at the Federal Reserve Bank of Atlanta.
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