The world of asset markets heard the new US Federal Reserve chairman Jerome Powell for the first time on Tuesday. It did not like what it heard. But, they were music to my ears. He said: “After easing substantially during 2017, financial conditions in the United States have reversed some of that easing. At this point, we do not see these developments as weighing heavily on the outlook for economic activity, the labour market, and inflation. The FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2% on a sustained basis."
Powell’s prepared remarks were rather brief but telling. He does not think that financial market volatility will have a big bearing on economic activity. I agree. One hopes that it is not just about the current level of volatility but also reflects a structural attitude that assigns a lower weight to the goings-on in financial markets in terms of their impact on the real economy. Anna Cieslak and Annette-Vissing Jorgensen have documented this rather well. The Fed is more concerned about declines in financial asset prices than they ought to be. In reality, the impact is far lower than what Fed models assume.
His second statement is even more interesting. He is no longer talking about striking a balance between employment and inflation but between avoiding overheating and bringing inflation to 2% (from below). He is not going to be fixated on bringing inflation up to 2% from below. He will also keep an eye on overheating. Good for him!
It is perhaps the first time in nearly three decades that a Federal Reserve chairperson is referring to avoiding an overheated economy even while inflation is undershooting the target! Extraordinary stuff! Very interesting times ahead.
Nearly three months ago, Gavyn Davies wrote in a blog post for Financial Times that US president Donald Trump has the opportunity to shape the Federal Reserve board this year in an unprecedented manner:
“Including the promotion of Jerome Powell to chair, six of the seven board members will have been nominated by the current administration when the process is completed next year. In addition, the President of the New York Fed will have been replaced by its own board. Such a root-and-branch upheaval in the Fed’s key personnel is unprecedented in its history."
He predicted that the new Federal Reserve board would likely display the following tendencies:
■ “There may be more enthusiasm for expansionary fiscal policy, and greater belief in beneficial supply side effects from cuts in marginal tax rates;
■ There may be greater concern about possible instability from rising asset prices;
■ There may be greater willingness to reverse some of the regulatory restrictions in the Dodd Frank legislation;
■ There may be less emphasis on gradualism when it comes to raising interest rates;
■ There may be a greater eagerness to run down the balance sheet, especially in non-treasury assets;
■ There may be more emphasis on rules-based policy decisions, notably on the use of the Taylor Rule."
I like most of the above. In fact, I think Jerome Powell alluded to the second item in the above list when he spoke of balancing between overheating considerations and bringing inflation up to 2%.
I was surprised that many have not cottoned on to his comment about balancing between avoiding an overheating economy and bringing inflation to 2%. John Authers, here, notes that his message was not too different than that of predecessor Janet Yellen but that he delivered the message in a business-like fashion. I disagree. The message was starkly different.
It is the first time in a long time that a Fed chair mentions overheating risks while trying to bring inflation back up to 2%!
In November 2017, Stephen King (formerly with HSBC) wrote a nice piece in FT suggesting that “central banks that focus on price stability alone may only be stoking the next financial bubble".
We may have found a central banker who wants to put an end to that practice. Powell’s testimony means that US real rates are headed higher. More strength to him.
Usually, Fed chairpersons talk of overheating only with reference to an inflation rate that is above target. Here is a Fed chairperson talking of overheating, independent of inflation and especially when inflation is below target. This means US real rates are headed higher and that is rather bullish for the dollar. But negative for stocks and bonds.
The risk to the above call on the US dollar is that the Trump administration gets very testy about it, about the fallout on the asset market and gets into a public spat with the Federal Reserve.
That would be very negative for American assets and negative for the dollar too. In either scenario, financial assets are in trouble. For now, I would bet on him being able to carry out his agenda.