Fed’s challenge may become more daunting
Investors have a rude way of welcoming new leaders at the Federal Reserve.
Two months after Alan Greenspan became chairman in 1987, the stock market suffered its biggest one-day percentage fall in history.
When Ben Bernanke took over in early 2006, the bubble in subprime U.S. real estate had just begun leaking, eventually triggering the global financial crisis.
By those standards, the abrupt 10% plunge in stock prices that greeted new Fed chairman Jerome Powell last week might seem fairly tame. And over the near-term, the return of downside volatility does not argue for any changes in the Fed’s plan to gradually normalize monetary policy.
Before long, however, Powell could face at least as daunting a task as Bernanke, and probably a more potentially perilous one than Greenspan.
Given the market’s extreme reaction to even sketchy evidence that inflationary pressures are building, investors might take comfort in knowing that the pragmatic Powell succeeded Janet Yellen, rather than one of the more ideologically rigid candidates considered for the post.
Still, the odds of a policy mistake have grown uncomfortably high and the consequences unusually severe. Like that engine warning light on your car dashboard, the factors that cause market tremors generally do not go away, even if they temporarily fade into the background.
Bad timing
It’s been known for months that central banks in Asia, Europe and the United States were in the early stages of phasing out the easy money policies that propped up asset prices since the Great Recession in 2008.
Short-term interest rates — the policy lever directly under central bank control — already were rising in the U.S., even as the Fed curtailed purchases of government bonds by not reinvesting the proceeds of maturing debt.
Though inflation has stayed stable at about a half percentage point below the Fed’s 2% target, several factors coalesced to disrupt the complacency that underpinned a virtually unprecedented run of market tranquility.
If sustained, the 2.9% year-over-year increase in average hourly earnings reported in January could cause inflation to rise more than investors and policy-makers had expected.
That, in turn, would put additional upward pressure on bond yields that have been rising because of reduced Fed buying, sharply higher oil prices and the $1.5 trillion tax cut enacted in December.
To be sure, the tax cut was not like pouring gasoline on a raging fire. Economic growth in 2017 was more than a percentage point below the 3.4% average of the previous 70 years.
Still, global growth was accelerating and synchronized, the dollar was falling and the U.S. was close to full employment.
Taken together, those factors are tailor-made to produce higher inflation, the bane of fixed-income investors and the archenemy of the Fed.
Under such circumstances, tax cuts that may have been appropriate during a recession or shortly thereafter were ill-timed at best and selfdefeating at worst.
Old problem returns
The tax cuts are likely to add at least $1 trillion to the national debt, which the nonpartisan Congressional Budget Office projects will reach $29 trillion by 2028.
Meanwhile, budget deficits are expected to rise significantly from the current 3.4% of gross domestic product, putting annual shortfalls in the vicinity of those that contributed to dollar weakness in the mid-1980s and eventually to the stock market crash in 1987.
Already, the impact of lost tax revenue is being felt in the bond market as a doubling of the Treasury’s borrowing needs for the current fiscal year — along with rising inflationary expectations from faster economic growth — have pushed yields to four-year highs.
In effect, the supply of
Still, the odds of a policy mistake have grown uncomfortably high and the consequences unusually severe. Like that engine warning light on your car dashboard, the factors that cause market tremors generally do not go away, even if they temporarily fade into the background.
government debt is soaring just as demand for it is shrinking.
History gives no clear answer about how much farther bond yields could rise, though the stratospheric numbers of the 1980s appear to have been an aberration tied to lingering (and unreasonable) fears of inflation.
Aside from that turbulent decade, real 10-year bond yields have converged around 2% over a full cycle, suggesting that long-term rates could move up by another half-percentage point, and significantly more if the Fed losses credibility as an inflation fighter or federal budget deficits aren’t reduced.
The latter seems especially problematic. Welcome aboard Jerome Powell.
Tom Saler is an author and freelance journalist in Madison. He can be reached at tomsaler.com.