5 February 2018

Can Jay Powell provide the punch the Fed needs?

By

William McChesney Martin, long-time chairman of the Federal Reserve, famously said that the US central bank’s most important task was to “take away the punch bowl just as the party gets started”. The quotation’s conceited paternalism chimed well with the post-war Keynesian doctrine that aggregate demand could and should be managed by the high priests of economic authority.

Much has happened to the American economy in the intervening decades. Monetary policy has been at the heart – when not itself the heart – of macroeconomic fluctuations: from the accelerating inflation of the late 1960s and ’70s, through the orthodoxy which successfully tamed the price level under Paul Volcker, to the mirage of the Great Moderation over Alan Greenspan’s tenure and, latterly, the unprecedented experiment in monetary stimulus, and its tapering, under Ben Bernanke and Janet Yellen.

Long gone are the days when Fed chairmen elicited the reverence of politicians, businesspeople and journalists alike. Greenspan, dubbed “the maestro” by the end of his 19-year tenure, probably marked the high point of the central banker cult. Then came the financial crash and Great Recession, widely viewed as having discredited Greenspan in particular, and monetary managers’ claim to omniscience in general.

Whilst the power of central bankers is still recognised and was encapsulated by ECB boss Mario Draghi’s pledge to do “whatever it takes” to sustain the euro, no longer are their obscure pronouncements and grandiloquent vows greeted with unquestioning awe. Instead, central bankers are increasingly regarded as akin to other public officials: imperfectly informed and ambiguously motivated.

This is the environment in which Janet Yellen, the outgoing Fed chairwoman, has operated for the past four years. Widely seen as a policy dove upon taking office, Yellen has nevertheless had to manage the first stages of monetary normalisation: winding down quantitative easing and progressively raising the Fed’s interest rate target.

History has shown that the effects of monetary policy can lag behind the intervention that caused them by several years. Thus any definitive verdict on Yellen’s tenure will have to wait. But the evidence so far suggests that the Fed’s timing of normalisation has been well-received by markets. Bond yields have only gradually risen. There is also no sign of a repeat of the “taper tantrum” which followed Bernanke’s 2013 announcement that the Fed’s post-crisis asset purchases would be progressively wound down.

Better-than-expected growth figures, continued declines in unemployment, as well as the expectation of higher demand from tax cuts and infrastructure spending have all lifted inflation expectations, creating room for the Fed funds rate target to continue to rise. By all these measures, the Yellen normalisation has been a textbook one.

Yet, whilst the outgoing Fed chair leaves her successor Jerome “Jay” Powell a stable short-run picture, she has done little to address the longer-term challenges facing monetary policy. The most salient among them is existential: can central banks in fact improve macroeconomic outcomes in any reliable way? The Great Recession did not turn into a full-blown depression, for which many credit the Fed’s emergency measures. But even if depression prevention, what the Nobel Laureate Robert Lucas called the “central problem” of macroeconomics, has been solved, the business cycle remains an inescapable fact of economic life.

The Fed’s two-pronged mission is to keep prices stable and unemployment low. But the US price level has steadily risen since the Fed’s creation, even as it had remained broadly stable in the century prior. Unemployment, on the other hand, continues to fluctuate widely, and the recent role of the US central bank in spurring job creation has been mixed: unemployment is down, but so is the labour force participation rate.

The last crisis also exposed the Fed’s potentially destabilising role in the financial sector. Some argue that it erred by omission, failing to curtail excessive bank leverage and irrational exuberance in mortgage markets, whilst others accuse it of actively contributing to the crash by keeping interest rates too low for too long.

Either way, the glaring failure to anticipate the scale of the meltdown has tarnished the Fed’s reputation as much as 1970s stagflation did. But unlike the late 1970s, when there was a clear alternative blueprint – monetarism, or cutting back on money growth – which Paul Volcker could implement, the remedies adopted after 2008 have failed to convince. Jay Powell himself has stated that the massive regulatory drive that followed the crash may require fundamental reassessment. His scepticism is buttressed by mounting academic evidence that the morass of new rules may be hurting bank lending, and thus investment and productivity growth.

More broadly, Powell will have to grapple with the Fed’s increasing inability to meet its inflation target. The possible causes are manifold: greater slack in the economy than anticipated by policymakers, subdued inflation expectations, and a miscalibration of policy – which would fail to affect target variables in the desired way – all fit the bill. Regardless, the blame lies squarely with the central bank. It raises the possibility that the Fed will, in the medium term, consider changing its policy target so as to better fulfil its function.

The best candidate for an alternative measure is nominal output growth, which incorporates both real GDP growth and inflation. Its supporters, who include Bentley University’s Scott Sumner and the Cato Institute’s George Selgin, argue that such a spending target would minimise the fluctuations caused by monetary policy. Because the growth rate of nominal GDP would be fixed, the Fed would have to inflate at times when real growth was low and to restrain money growth when the economy was booming. Inflation would thus run consistently above trend in recessionary times, boosting economic activity and minimising the need for other measures such as Keynesian stimuli.

Is Powell the man to deliver such long-standing policy change? He has been described as dovish but sceptical of regulation, the kind of easy-money Republican which a pro-business administration would favour. Nominal GDP targeting, because it reduces the need for activism by other branches of government, might therefore appeal to him.

Many will agree with McChesney Martin that management of the monetary punch bowl remains the Fed’s most important function. But without a suitable punch recipe, monetary policy risks becoming ever more ineffective. Whether Jay Powell will deliver the required transformation is as yet unknown.

Diego Zuluaga is Head of Financial Services and Tech Policy at the Institute of Economic Affairs.