Which of these two developments strike you as a bigger risk to economy?
A. An annual inflation rate of only 1.6 percent instead of the target of 2 percent; or
B. A stock market levitating at record levels as a result of artificially low interest rates, record levels of corporate indebtedness and stock buybacks, an orgy of richly priced mergers and initial public offerings and a trillion-dollar federal budget deficit at a time of full employment?
If you answered B, then — congratulations! — you pass the 10-second sanity test offered by the Society of American Economic Historians.
If you answered A, then you might want to apply for one of the two still-open seats on the Federal Reserve Board, where you will feel right at home with other policymakers who appear to have learned nothing from the past four recessions.
Over the past 30 years, it’s not a tightening of monetary policy by the Fed in response to inflation that has caused recessions, as was the pattern for most of the 20th century. Rather, in the current era of low inflation, it has been the failure to tighten monetary policy when asset bubbles develop that has led to recessions when those bubbles burst and bring the economy down with them.
That’s what happened with the junk bond bubble and the savings and loan crisis of the late 1980s, with the telecom and dot-com bubble of the early 2000s and, most recently, the mortgage and real estate bubble that nearly brought down the financial system only a decade ago.
Just before those crises, the Fed policymakers would assure us how fundamentally strong the economy was, how inflation was well contained, and how they would continue to be guided by the latest economic data but that, for the moment, everything was well in hand. And while they were careful to acknowledge that some asset prices might be slightly higher than normal, it was neither the job of the Fed to set asset prices nor within its competence to distinguish a healthy bull market from bubble. Even if there were a bubble, they argued, these were problems best dealt with through targeted bank regulation rather than using the blunt instruments of monetary policy.
Not surprisingly, that was exactly the same script followed by Chair Jerome H. Powell this past week in explaining why the Fed had left interest rates unchanged, and why it would soon halt its efforts to soak up some of the $2 trillion it printed during the recent Great Recession. To those old-timers listening, it felt like Bill Murray in the movie “Groundhog Day.”
Indeed, Larry Fink, chairman of BlackRock, the world’s largest asset management company, said recently that it wasn’t a “meltdown” on financial markets he was most worried about, but a “melt up,” which is just what has happened since the Fed waved the white flag at the end of December and announced it was halting what was expected to be a long, slow increase in interest rates after keeping them near zero for eight years.
Back in December, Powell rationalized the surrender to himself and to the country as a response to sudden weakening economic data, which in the end turned out to be transitory, as evidenced by Friday’s news that 263,000 jobs were added to payrolls in April. But in reality, Powell — a former investment banker who remains closely attuned to signals from Wall Street — hadn’t been moved by the data. He was spooked by the 20 percent drop in stock prices in the last quarter of 2018.
In the context of an eight-year bull run that had seen stock prices climb by 300 percent, a 20 percent decline should have been viewed as the first phase of a necessary and welcome correction in asset prices. But with President Trump daily tweeting his displeasure and the Wall Street propaganda machine shifting into high gear to blame the Fed for the coming recession, Powell and his colleagues lost their nerve, declaring there would be no further rate hikes any time soon. Triumphant traders piled back into the market, confident the Powell Fed had been whipped into submission.
There are, of course, times, such as when consumer and business confidence is in a free-fall and unemployment is heading toward double digits, when it’s the Fed’s job to try to put a floor under asset prices. That’s one of the well-recognized channels through which monetary policy is supposed to work. But doing so when the economy is operating at full capacity simply to add a few tenths of a percent to the inflation rate is monetary malpractice in today’s global low-inflation environment.
What the mandarins at the Fed seem incapable of acknowledging is that they no longer control the cost or the supply of money in the economy and the financial system in the way they once did. Part of it is that global financial flows are so large that they can confound the policies of any one country’s central bank, even the Fed.
And part of it is that, with the unregulated “shadow” banking system responsible for more than half of all credit creation, the financial system and the economy can be at risk even if the regulated banks are not.
In this new world, the only way monetary policy can achieve its goals of economic and price stability is to use its interest rate policy to tame the boom and bust cycles of financial markets by leaning against asset and credit bubbles and offsetting the overly stimulative effects of runaway deficit spending.
Is there a risk they will get it wrong by taking the punch bowl away too soon and, in the process, lose the opportunity to drive unemployment even lower and drive wages and profits and stock prices even higher? Sure.
But the risk is even greater that all the gains from an extra year of economic growth will be more than wiped out if that extra growth is fueled more by cheap debt and excessive risk-taking than by a genuine increase in productivity, and a burst bubble leads to deep recession that takes years from which to recover. We know from behavioral economics that people would rather avoid a dollar of loss even if it means foregoing a dollar of gain. And we know from recent history that it is the working class, not the investing class, that suffers most from the boom and bust cycle that the Fed has been reluctant to tame.
The central challenge facing the modern Fed is to figure out a way for the economy to operate at full employment without being reliant on cheap money and asset bubbles to generate growth. I don’t pretend that figuring out how to meet that challenge will be easy or self-evident.
But I do know that we’ll never get close as long as policymakers have convinced themselves that it’s just about keeping a close eye on the economic data and keeping inflation at precisely 2 percent. Monetary policy now requires the Fed to use all of its powers to tame the excesses of financial markets. And that can happen only if the markets are more afraid of the Fed than the Fed is of the markets.