Sebastian Mallaby, author of “The Man Who Knew: The Life & Times of Alan Greenspan,” is the Paul A. Volcker senior fellow for international economics at the Council on Foreign Relations and a contributing columnist for The Post.
Prudence and predictability are not exactly plentiful in President Trump’s Washington. But sometimes there can be too much of these virtues, and that is the danger confronting the Federal Reserve under Janet Yellen.
When Yellen and her colleagues meet next week, Wall Street confidently expects them to nudge interest rates up by a quarter of a percentage point, a move that would acknowledge the strength of the economy yet avoid kicking over the apple cart with a more brutal adjustment. But, contrary to conventional wisdom, the central bank should want to spill some apples. Wall Street is complacent. It could use a surprise kick.
To see why this is so, start with some quick history. For half a century after World War II, U.S. recessions came about because spending grew faster than production, inflation picked up, and the Fed had to raise interest rates and choke growth to force inflation down again. That changed in the 1990s. Globalization and technological advances put a lid on inflation: Cheap imports restrained prices; the ability to replace workers with machines checked wages. Meanwhile, the Fed under Alan Greenspan convinced everyone that inflation had been permanently vanquished, which further dampened the old habit of marking up prices.
And so, in 2001, the United States experienced a different kind of recession: one that was heralded not by inflation but rather by the implosion of a stock bubble. In 2007, another and much nastier bubble burst, this time in real estate: The result was the second recession of the 21st century. All through that tumultuous decade, the price of eggs in your local grocery store remained reassuringly stable. Nest eggs went crazy.
The next recession will probably follow this new pattern. The forces dampening inflation are still present: cheap imports, technological progress, a Fed that’s credibly committed to stable prices. Admittedly, the Trump administration could weaken these restraints: Trade protection or a “border tax” could force up the cost of imports; Trump could bash the Fed, undermining its credibility. But, until the Trump team takes those steps, it would be wise to assume that the next recession is more likely to result from an imploding bubble than from the Fed’s need to choke inflation.
Is bubble trouble imminent? In September, candidate Trump declared that the stock market was already in the grip of “a big, fat, ugly bubble.” Since then, the S&P 500 stock index has jumped more than 10 percent: If the market was ugly last fall, it must now be hideous. Of course, bubbles, by their nature, cannot be diagnosed with certainty. But by reasonable measures, we are in, or at least approaching, a danger zone. And the best time to tackle a bubble is early.
For Yellen and her colleagues, this should mean two things. First, they should raise interest rates a bit faster than they would if they were merely trying to restrain inflation. Next week’s likely quarter-point interest-rate hike would be based on the notion that inflation, while rising, is still low: The Fed’s preferred measure was up 1.9 percent in January over a year ago, a smidgeon below the target of 2 percent. But given the stock market’s exuberance, there’s a case for a larger increase than financial markets expect: instead of a quarter point, half a point. With unemployment below 5 percent, the economy seems strong enough to take this medicine. And interest rates would still be low by historical standards.
But second, and more important, the Fed should avoid being predictable. In the run-up to the subprime-mortgage crisis, its principal error was to telegraph that it would raise rates by a quarter-point per meeting, not more and not less. Thus reassured, banks such as Lehman Brothers were willing to borrow astronomically, believing that the cost of all this leverage would not spike suddenly and cause crippling losses. This time around, the markets need less of the steady parent and more of the crazy uncle.
A quarter-century ago, the Fed didn’t mind being unpredictable. When it rolled out a series of rate hikes in 1994, it did a quarter-point sometimes, half a point others, and a full-gun three-quarter-point ambush once. Financial traders who had borrowed too much short-term money lost their shirts, teaching everyone a valuable lesson about the perils of aggressive leverage. Meanwhile, ordinary companies and workers did fine. The Fed pricked a bubble in the bond market, but there was no recession.
Today’s Fed does not want to be responsible for containing the next bubble; deflating workers’ retirement savings is not a job that any institution would relish. But the clear lesson from history is that inflation is no longer the main enemy. Financial stability matters at least as much as price stability.
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