Photo: Bloomberg
Photo: Bloomberg

Opinion | Powell reinforces the Yellen-Bernanke-Greenspan put

The Federal Reserve is still in the business of writing ‘put’ options on the stock market for investors

In the course that I am currently teaching second-year students at the IFMR Graduate School of Business, topics such as potential gross domestic product growth, output gap and overheating came up for discussion recently. Overheating is language that economics has picked up from physics. When a machine is run above its rated capacity or if it runs for too long without a break, it will get overheated. The analogy fits perfectly with economies. The only problem is that in economics, overheating is inferred but not observed directly because the rated capacity—potential output growth—is a rather imprecise estimate.

Overheating can be seen in a high and accelerating inflation rate, in a lower-than-average unemployment rate, rampant credit growth, exuberance in asset markets, high and rising trade deficits, overvalued currency, and excessive risk-taking on the part of businesses and financial market participants. It is not necessary that all indicators must be present for a judgement to be formed on overheating. Other factors might restrain inflation but overheating might still be evident.

The American economy is nearing 10 years of expansion. The National Bureau of Economic Research dated the end of the last recession in June 2009. This could turn out to be the longest economic expansion in a long time. Yet, the rate of consumer price inflation is quiescent. Wage growth too has been restrained. America has always had a trade deficit and it is hard to argue that it has accelerated in recent times. If anything, even in absolute dollar terms, the trade deficit was bigger between 2006 and 2008. But asset markets have been exuberant. Excessive risk-taking is evident in the demand for high-yield or speculative bonds and in the record issuance of leveraged loans (loans made to companies that already have a high debt-to-equity ratio). In other words, overheating is far more readily apparent in the financial economy than in the real economy. That has been the case with developed economies since the 1990s, if not earlier.

In this milieu, candidate Donald Trump railed against the low-interest rate policy of the Federal Reserve benefiting Wall Street insiders. His final campaign video mentioned this prominently. He appointed Jerome Powell who was not an academic-economist. Academic-economists write textbooks extolling monetary policy and expound the limitations of fiscal policy. Elected and accountable politicians make fiscal policy. Unaccountable technocrats make monetary policy. Unsurprisingly, they credit themselves with better judgement than politicians with no concrete evidence to back up their claims.

The rate of inflation since the 1980s has declined due to multiple factors, the chief one being labour insecurity and anxiety, and restrained wage growth. The inefficacy of monetary policy has been starkly evident in their failure to stoke inflation despite flooding the economy with money and despite holding interest rates at zero for several years. While textbooks claim that monetary policy is a policy to boost short-run aggregate demand , it has given way to a semi- or near-permanent state of monetary easing. Monetary policy had become the only game in town both in the short run and in the long run with nothing much to show for it, except higher income and wealth inequality, record prices in asset markets and higher corporate debt levels issued to finance share buy-backs or make risky acquisitions.

Powell, the chairman of the US Federal Reserve, was widely expected to restore the role of monetary policy as a tool to regulate the short-run aggregate demand rather than being a price-support mechanism for asset markets. He began well but he has been tamed. Early in January, Powell said that he was listening to financial markets carefully. Now, there are signs that the Federal Reserve would also stop shrinking its balance sheet too. Financial markets have dealt a double blow to the Federal Reserve. Powell has delivered more than what his financial market critics had asked for. The Federal Reserve is still in the business of writing “put" options on the stock market for investors. Never mind that, post-2009, the Davos men (and very few women) have become disproportionately wealthier than the median worker (see Davos Billionaires Keep Getting Richer, Bloomberg, 20 January).

In the process, the Federal Reserve may have also thrown a lifeline to the struggling China economy. Tighter monetary policy and a stable-to-strong dollar will have made China’s fragile economy more vulnerable to an economic collapse, serving America’s long-term geopolitical objectives. A recent analysis by Chatham House (How US Monetary Policy Tamed Chinese Foreign Policy, 17 January 2019) reminds Trump of the geo-economic benefits of America’s tighter monetary policy but to no avail. Alternatively, it might have also made China behave better. Yours truly had written that taming finance would tame China too (Mint, 18 April 2018) and that monetary policy had to play its part in both. As in 2016, that chance has been blown yet again. Finance and China have tamed Trump and Powell.

V. Anantha Nageswaran is dean of IMFR Graduate School of Business (KREA University). These are his personal views.

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