“The in­sti­tu­tion Pow­ell will now head rules the global fi­nan­cial sys­tem. All other cen­tral bankers, fi­nance min­is­ters, and even pres­i­dents run a dis­tant sec­ond”

Financial Mirror (Cyprus) - - FRONT PAGE -

With the ap­point­ment of Jerome Pow­ell as the next Chair of the United States Fed­eral Re­serve Board, Don­ald Trump has made per­haps the most im­por­tant sin­gle de­ci­sion of his pres­i­dency. It is a sane and sober choice that her­alds short­term con­ti­nu­ity in Fed in­ter­est-rate pol­icy, and per­haps a sim­pler and cleaner ap­proach to reg­u­la­tory pol­icy.

Although Pow­ell is not a PhD econ­o­mist like cur­rent Fed Chair Janet Yellen and her pre­de­ces­sor, Ben Ber­nanke, he has used his years as an “or­di­nary” gover­nor at the Fed to gain a deep knowl­edge of the key is­sues he will face. But make no mis­take: the in­sti­tu­tion Pow­ell will now head rules the global fi­nan­cial sys­tem. All other cen­tral bankers, fi­nance min­is­ters, and even pres­i­dents run a dis­tant sec­ond.

If that seems hy­per­bolic, it is only be­cause most of us don’t re­ally pay at­ten­tion to the Fed on a day-to-day ba­sis. When the Fed gets it right, price sta­bil­ity reigns, unem­ploy­ment re­mains low, and out­put hums along. But “get­ting it right” is not al­ways easy, and when the Fed gets it wrong, the re­sults can be pretty ugly.

Fa­mously, the Fed’s ef­forts to tame a stock-mar­ket bub­ble in the late 1920s sparked the Great De­pres­sion of the 1930s. (For­tu­nately, of the can­di­dates Trump was con­sid­er­ing for the Fed post, Pow­ell is the one least likely to re­peat this mis­take.) And when the Fed printed moun­tains of money in the 1970s to try to dull the pain of that decade’s oil shocks, it trig­gered an in­fla­tion­ary surge that took more than a decade to tame.

At times, the rest of the world seems to care more about Fed pol­icy than Amer­i­cans do. Lit­tle won­der: per­haps more than ever, the US dol­lar lies at the heart of the global fi­nan­cial sys­tem. This is partly be­cause much of world trade and fi­nance is in­dexed to the dol­lar, lead­ing many coun­tries to try to mimic Fed poli­cies to sta­bilise their ex­change rates.

Pow­ell will face some ex­tra­or­di­nary chal­lenges at the out­set of his five-year term. By some mea­sures, stock mar­kets look even froth­ier to­day than they did in the 1920s. With to­day’s ex­traor­di­nar­ily low in­ter­est rates, in­vestors seem ever more will­ing to as­sume greater risk in search of re­turn.

At the same time, de­spite a strongly grow­ing US and global econ­omy, in­fla­tion re­mains mys­ti­fy­ingly low. This has made it ex­tremely dif­fi­cult for the Fed to nor­mal­ize pol­icy in­ter­est rates (still only 1%) so that it has room to cut them when the next re­ces­sion hits, which it in­evitably will. (The odds of a re­ces­sion hit­ting in any given year are around 17%, and that seems like a good guess now.)

If Pow­ell and the Fed can­not nor­malise in­ter­est rates be­fore the next re­ces­sion, what will they do? Yellen in­sists that there is noth­ing to worry about; the Fed has ev­ery­thing un­der con­trol, be­cause it can turn to al­ter­na­tive in­stru­ments. But many econ­o­mists have come to be­lieve that much of this is smoke and mir­rors.

For ex­am­ple, so-called ‘quan­ti­ta­tive eas­ing’ in­volves hav­ing the Fed is­sue short-term debt to buy up long-term gov­ern­ment debt. But the US Trea­sury owns the Fed, and can carry out such debt pur­chases per­fectly well by it­self.

Some ar­gue for “he­li­copter money,” whereby the Fed prints money and hands it out. But this, too, is smoke and mir­rors. The Fed has nei­ther the le­gal au­thor­ity nor the po­lit­i­cal man­date to run fis­cal pol­icy; if it tries to do so, it runs the risk of for­ever los­ing its in­de­pen­dence.

Given that mon­e­tary pol­icy is the first and best line of de­fense against a re­ces­sion, an ur­gent task for the new chair is to de­velop a bet­ter ap­proach. For­tu­nately, good ideas ex­ist, and one can only hope that Pow­ell will quickly move to cre­ate a com­mit­tee to study long-term fixes.

One idea is to raise the Fed’s in­fla­tion tar­get. But this would be prob­lem­atic, not least be­cause it would breach a decades-long prom­ise to keep in­fla­tion around 2%. More­over, higher in­fla­tion would in­duce greater in­dex­a­tion, ul­ti­mately un­der­min­ing the ef­fec­tive­ness of mon­e­tary pol­icy. Paving the way for ef­fec­tive neg­a­tive-in­ter­est-rate pol­icy is a more rad­i­cal – but by far the more el­e­gant – so­lu­tion.

Bank reg­u­la­tion is also part of the Fed’s man­date. The 2010 Dodd-Frank fi­nan­cial-re­form leg­is­la­tion, which has spawned 30,000 pages of rules, has been a boon for lawyers. But the mas­sive com­pli­ance costs ul­ti­mately fall on small and medium-size busi­nesses. It would be far bet­ter sim­ply to re­quire banks to raise much more of their re­sources in eq­uity mar­kets in­stead of through bonds. That way, share­hold­ers, not tax­pay­ers, would take the big hit in a cri­sis.

I have not men­tioned the ele­phant in the room: the threat to the Fed’s in­de­pen­dence posed by a pres­i­dent seem­ingly in­tent on chal­leng­ing all in­sti­tu­tional norms. When Pres­i­dent Richard Nixon was in­tent on be­ing re-elected in 1972, he put heavy pres­sure on then-Fed Chair Arthur Burns to “juice” the econ­omy. Nixon was re-elected, but in­fla­tion soared and growth col­lapsed. No one should be wish­ing for a re­play – even if Nixon even­tu­ally was im­peached.

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