Powell Better Brush Up on His Fed History
(Bloomberg Opinion) --
Volcker, Powell and the Importance of Keeping At It
With what seems like indecent haste, markets move from the U.S. midterm elections on Tuesday to the conclusion of a Federal Reserve meeting on monetary policy Thursday. This Federal Open Market Committee meeting, if all goes according to plan, will be the last one that is not followed by a news conference. Chairman Jay Powell now intends to talk to the press after all eight meetings each year, rather than the four press conferences instituted by former chairman Ben S. Bernanke.
Beyond marking another step in the road toward central bank transparency, this FOMC meeting is unlikely to matter much. Interest rates will not be changed, and neither will the ongoing shrinkage of the Fed’s balance sheet assets. There may be some hints in the language that the Fed sees the economy as stronger than it did at the last meeting in late September. The potential return of political gridlock as a result of the midterms also reduces the danger that the Fed finds itself in a confrontation with President Donald Trump over further fiscal stimulus.
A Republican House in control of the federal checkbook might easily have opted for further fiscal stimulus, whether through unfunded tax cuts, unfunded extra spending, or both. That would have increased the pressure on the Fed to tighten monetary policy to keep the economy from overheating and inflation from accelerating. To illustrate this, see the behavior of the bond market as the midterm results were reported:
For an hour or so, as Republicans made several hoped-for gains in the Senate while Democrats failed to make a number of hoped-for gains in the House, a “red wave” that allowed the GOP to retain control of both chambers of Congress seemed a real possibility. That was enough to push the 10-year Treasury note yield to 3.25 percent for the first time since early 2011. Then, in a bizarre moment, Fox News announced that it was calling the House for the Democrats, a bold call that would soon be vindicated. Yields immediately sank below 3.20 percent. A divided Congress is a far less menacing scenario to markets. It should also make life easier for the Fed.
Not only politics is falling in line with predictions for a change. For the last few months, the economic data have also run consistently close to expectations, in a way that has arguably not been seen before this decade. The Citigroup U.S. Economic Surprise index is set so that 0 is equivalent to data in line with expectations while numbers above and below show positive and negative surprises:
But a development on Wednesday afternoon rammed home the notion that Powell’s job over the next few years will not be easy. It was not the firing of Jeff Sessions as attorney general. Rather, it was the far less exciting news that the latest auction of 30-year Treasury bonds was poorly received by investors. That caused bond yields to rise from their lows of the day, suggesting bond investors feel that the risks point toward overheating and inflation rather than an imminent recession.
The Trump administration’s massive unfunded corporate tax cut is forcing the government to ramp up its borrowing, pressuring bond yields higher, while the Fed may need to keep boosting rates to contain inflation. Such a stance brings with it the increased risk of conflict with the President Donald Trump, who recently described Powell as “loco” for raising rates. It also increases the risk of a so-called hawkish error, which is the risk that the Fed raises rates too high, too fast and causes a recession or some other mishap.
Bloomberg’s World Interest Rate Probabilities (WIRP) model shows the strong chance of two rate increases next year, following a hike next month. The chance of three hikes in 2019, the median prediction of the Fed, is now about one in three. Money markets suggest that two increases for next year are priced in.
So how should Powell approach the task? I suggest he look at the actions of two of his predecessors, Paul Volcker and Alan Greenspan, and take a very long view. Volcker, who is now in his 90s, just published a memoir called “Keeping At It” that was written with the help of Bloomberg Markets editor Christine Harper. You can hear her talk about this project here. In his review of the book, my former colleague and mentor at the Financial Times, Martin Wolf, described Volcker thusly:
Paul Volcker is the greatest man I have known. He is endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country.
That view is not out of place. Volcker is as close to a universally revered figure in the world of finance as any that I have seen in my lifetime. For another review, try this one by my new colleague, Bloomberg Opinion columnist Albert Hunt. Volcker came into conflict with presidents, and commended Powell for his handling of Trump’s criticisms. To listen to Volcker talk about the challenges he faced, and inveigh against what Washington has become, listen to this podcast produced my former colleagues at the FT from an interview last month with Gillian Tett. (It is clear from Volcker’s voice that he is not in good health.)
Volcker’s place in history as the man who boldly took on inflation and slew it, opening the way for great American prosperity in the late 1980s and 1990s, is secure. I mention this because that was not his reputation while he served as Fed chairman from 1979 until 1987, or immediately after he left. Secrets of the Temple, a great piece of financial journalism by William Greider, was published in 1988 just after Volcker stepped down. It is brilliantly written and researched, and comes to a view on Volcker that most now would find unrecognizable. The first chapter is titled “The Choice of Wall Street,” and recounts how the Carter administration determined that he would pass muster with bankers. Greider’s conclusion on his victory over inflation is as follows:
The triumph was hollow, however, for the nation. Its moral promises to the victims were not kept. For the entire society, its predicted benefits were not realized. Paul Volcker and the central bank had taken the country and nations around the world through great suffering.
Once inflation was stabilized, Greider said, “the economy still faced the same underlying problems it had encountered in the era of inflation – only they were now more severe.” Volcker’s departure came after President Ronald Reagan appointed governors to the Fed who voted down a Volcker proposal to raise rates.
Now, let’s look at another book, “Maestro,” written by the great Washington Post journalist Robert Woodward about Volcker’s successor, Alan Greenspan. It was published in 2000, just as the dot-come bubble was bursting, and told the story of Greenspan’s masterly handling of the economy. Describing the exceptionally strong economic conditions of 2000 as the “Greenspan dividend,” Woodward called his subject “the symbol of American economic preeminence.”
Greenspan’s reputation is different now. He is widely viewed as one of the chief culprits of the financial crisis, cutting rates whenever stock markets seemed to run into trouble, and thereby inflated an epochal credit bubble. This view of him may also pass, but the change in how he is viewed compared to when he left office a hero in 2005 is nothing short of staggering.
Woodward’s account of a conversation Greenspan had with President Bill Clinton before he was re-appointed Fed chairman is revealing.
“Mr President,” Greenspan replied, “I couldn’t have done it without what you did on deficit reduction. If you had not turned the fiscal situation around, we couldn’t have had the kind of monetary policy we’ve had.”
Never was truer word said. Tight fiscal policy enabled the Greenspan Fed to be operate a generous monetary policy. It may even have tempted them to be too generous. Judgements were initially positive, but in time became damning. The Volcker Fed, faced with a far tougher fiscal situation, opted for the unpopular path of higher rates, and came into conflict with the presidency. Judgment at the time was damning, and with the fullness of time it has become glowing.
Powell will have to contend with extremely loose fiscal policy. If he cares for his long-term reputation, this means he will not have the chance to be as accommodating as Greenspan was. He will probably have to be as tough as Volcker was, and put up with deep unpopularity in the present. He will also have to suffer the slings and arrows of Trump insults. History, at least, might reward him.
Trump’s distinctive hair style has never been called “The Goldilocks,” as far as I am aware, but he now faces what might be a Goldilocks scenario both for his political future and the economy.
Politically, he now has a House of Representatives whom he can treat as an opponent (he is always at his best when in a fight), and who he can blame for problems with the economy. The chances are very strong that the Democrats will let him do this.
By virtue of the Republicans strengthening their hold on the Senate, Trump’s ability to nominate more conservative Supreme Court justices should the opportunity arise is unrestricted. This assures fealty from Christian conservatives.
Meanwhile, a House controlled by the Democrats should be able to stop him from doing things he might regret in the financial sphere, such as spend too much or give away too much in the form of lower taxes.
For the markets, this is also close to a Goldilocks position. The new personnel have been installed at the Fed, and will stay in place throughout this term. The chance of even more borrowing and even wider budget deficits has diminished. The big wave of deregulation is already in the books and not under threat to be reversed. With Republicans in control of the Senate, there is now minimal risk Trump will be impeached. Gesture politics might happen, but nothing that might really scares the markets.
There is one great hope for politicians and investors alike, which is that somehow Congressional Democrats and the White House can agree on a meaningful infrastructure program. It is unlikely, but both sides agree on such a thing, so it is not out of the question, and markets would love it.
There are two fears. One is of brinkmanship over the federal budget. Republicans probably regret their government shutdowns in the past when trying to undermine Democratic presidents, but it is always possible that the Democrats will try the same thing. Any doubts the federal debt ceiling wouldn’t be lifted could be very damaging – as we learned in 2011.
The second is trade. There will be renewed interest in the renamed North American Free Trade Agreement, where Democrats will probably move for a tougher deal on labor standards. But on China, the Democrats may well be closer to Trump’s ideals than many in his own party.
Partisan Conflict: The Federal Reserve Bank of Philadelphia has something called the Partisan Conflict Index, and I am ashamed to admit that I had never heard of it. I am also stunned by some of the things it reveals. Apparently, partisan conflict has been easing recently. Also, it was not that high when the Iran-Contra scandal and the nomination of Robert Bork to the Supreme Court roiled the Capitol in the summer of 1987, or even when the House voted to send President Clinton to an impeachment trial in the summer of 1998. The great peaks were the ill-advised government shutdown in 2013, and the immediate aftermath of Trump’s election victory in 2016. What are the chances that it makes another high in the next two years?
The Fear Index: I had taken the position that these U.S. midterm elections would not matter much to markets. I still stand by that. The the odds on the election outcome were virtually unchanged throughout the market turbulence of October, and the results turned out to be almost exactly in line with expectations. But I have to admit it is interesting to see how the VIX volatility index dropped on Tuesday morning, while the S&P 500 Index rebounded. It does seem strange that the so-called Fear Gauge dropped so much, when investors did not appear to be that fearful about politics in the first place.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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